 Income tax 2022-2023, depreciation of rental property basics part number one. Let's do some wealth preservation with some tax preparation. Most of this information comes from publication 527 Residential Rental Property including Rental of Vacation Homes Taxure 2022 you can find on the IRS website IRS.gov IRS.gov. Looking at the income tax formula we're focused on line one income. Remember in the first half of the income tax formula is in essence an income statement but just an outline other forms and schedules flowing into these line items. One of those the Schedule E basically an income statement in and of itself with rental income minus rental expenses. The net rental income flowing into line one income of the income tax formula. We're focused now on depreciation which is a very key component when we're talking about rental property because the cost of the property is going to be one of the major costs and depreciation related to that cost will be one of the major expenses which will have a significant and material impact on the income taxes for the rental property. Support accounting instruction by clicking the link below giving you a free month membership to all of the content on our website broken out by category further broken out by course. Each course then organized in a logical reasonable fashion making it much more easy to find what you need than can be done on a YouTube page. We also include added resources such as Excel practice problems PDF files and more like QuickBooks backup files when applicable. So once again click the link below for a free month membership to our website and all the content on it. Now note as we talked about in prior presentations oftentimes the rental property will be accounted for using a cashed based system and that's because we don't have anything requiring us to basically convert to an accrual system such as tracking inventory or something like that. But even if we're using a cashed based system there are some times that we have to deviate from that because the tax code tells us we have to to an accrual system and the most complete clear component of that or the most clear example of that would be with the property itself. So if you buy a piece of property if you buy a piece of a house a house that you're going to be renting for example then even if you paid completely cash for it it would be a huge distortion between the time frame that you used the property in order to generate revenue and the time frame that you actually paid for the property if you were able to depreciate deduct the cost of the property when you purchase it. So instead we have to do an accrual type thing which is to put it on the books as an asset an investment in essence an asset that's going to help us generate revenue in the future and then depreciate the cost over the useful life which is generally a pretty long extended time frame so there's this big difference in terms of the timing of when we get to get the benefit of the cost of the purchase of the property. Now note this is similar concept to depreciation of like equipment for example but it's a little bit different as well it could be confusing when we think about real estate because when you think about depreciating a piece of equipment like a forklift then clearly when you buy the forklift the expectation is that the forklift will go down in value over the life of the forklift and eventually it'll be obsolete useless and you're trying to basically allocate allocate blame the cost over the useful life when you're using that forklift to generate revenue same concept with depreciation we're buying the building so that we can use it consume it and generate revenue as we do so in the form of rent and the building does deteriorate go down in value over time but it's quite likely that we're also investing in the property in hopes that it goes up in value due to if not the wear and tear in the building just the location of the building so real estate is is unique in that case or at least different than most other depreciable property because most other depreciable property we expected to go down in value real estate we're hoping it actually goes up in value even though we're depreciating it over time alright that said depreciation of rental property you recover the cost of income producing property through yearly tax deductions you do this by depreciating the property that is by deducting some of the cost each year on your tax return so three factors determine how much depreciation you can deduct each year one your basis in the property to the recovery period for the property and three the depreciation as a depreciation method you use let's break that down a little bit more here if we buy a piece of rental property when you we from the tax per payer perspective the general rule would be that we would like to get the deduction sooner rather than later because of the time value of money so first question can I can I just depreciate can I just expense it when I buy it answer tax code says no because you have to put it on the books as an asset and then depreciate it and then well then the next question is well one of you know what do I have to include in the cost of the property is there anything that I could break out of the cost of the property and basically expense in the current time period so I can get the benefit sooner that's one of the questions we have and if we put it on the books as an asset then when do I get the benefit when do I get to allocate those those costs and that's going to be dependent on the number of years that we're going to be depreciating this thing over which is going to be determined primarily by the tax code and the depreciation method that we're going to be using the most common method being a straight line method other common methods for you know types of property or like double declining method trying to depreciate more upfront if we were able to do an accelerated method double declining versus straight line we would typically opt for that remembering that in the tax code our goal as a tax payer is usually to pay as less tax as possible which means we would like to get the deductions as soon as possible so if we can depreciate more upfront then later then that would be good so that's always kind of our mindset and then the tax code is kind of where we have to go to see how much they're going to restrict us to do from doing what we want to do all right so your bit your your basis in the property is basically you could think of like the adjusted cost of the property the things that you have to include and the cost of the property that you're going to then not be able to expense but rather have to depreciate over time the recovery period of the property the number of years that you're going to have to depreciate this thing over the depreciation method is it going to be a straight line method or double declining method even depreciation over the number of years or accelerated depreciation more in the current years than later years okay you can't simply deduct your mortgage or principal payments or the cost of furniture fixtures and equipments as expense so you can deduct depreciation only on the part of your property used for rental purposes so if you have a piece of property you're using part of it for rent and part of it for personal then obviously you can't depreciate the whole piece of property gets confusing then because you got one piece of property that you're going to have to divvy up in some way to calculate the depreciation just to wind back up over here notice they said you can't simply deduct your mortgage or principal payments so sometimes you might think the loan on the home kind of confuses people sometimes because you might be thinking well this goes back to the the statement of people often saying well I don't own the property the bank owns 80% of the property because they financed 80% of the property and originally I think that statement was an overstatement people are saying they're trying to be like modest or basically overstate by saying hey look I don't own the property the bank owns the property because I got a loan for 80% of it but that's not really the case of course because the bank can't tell you what to do with the rental property the bank doesn't sit at the kitchen table and tell you hey that rental property you've got to paint it green or something like that they're not making the decisions the bank only has recourse to the property if you default on the loan so what you have is ownership of the property and a responsibility to pay the loan the collateral on the loan being the property but sometimes people get confused and say well you know if the bank owns the property can't I deduct my whole mortgage payment not just the interest portion that would be a rent on the purchasing power but the whole payment of the mortgage and it's like well no you can't deduct the whole payment of the mortgage because that's a liability you're paying down the loan right on that so that's paying down the loan you might be you can deduct most likely the interest which is the rent on the purchasing power that you needed in order to purchase the property but not the payment of the principal of the loan okay so you can deduct depreciation only on the part of your property used for rental expenses depreciation reduces your basis for figuring gain or loss on a later sale or exchange what does that mean the basis in the property you can think of as in essence your cost of the property your adjusted cost which you had to include and then depreciate over time as you depreciate the property the book value of the property goes down so if you had 100,000 piece of property you depreciated 10,000 now it's got a nine thousand dollar basis that nine thousand ninety thousand dollars is still something you expect to get benefit from how you expect it to be depreciated until it goes down to zero over the useful life as you rent the property or when you sell the property it's going to lower the amount of gain that you're going to have because the gain is calculated as sales price minus the adjusted basis of the property so as a taxpayer we would like the basis to be as high as it could to some degree in other words when we put the property on the books we would like to expense it right off the bat and get that benefit now but they won't let us do that so we have to put it on the books as an asset and then at that point we would like the asset to be have as big a basis as possible in general because that allows us then to depreciate it over time or if we sell it it decreases the value of the gain the number of the gain of the amount of the gain and we pay taxes on gains because that would be like income or it increases the loss that we have at the sales which means could be good for taxes losses because we might be able to take them against other types of income so you may have to use form four five six two to figure and report your depreciation see which forms to use in chapter three also see publication nine four six all right the section one seventy nine deduction what about these big year one deductions that we often get when we're talking about equipment so the section one seventy nine deduction is a means of recovering part or all of the cost of certain of certain qualifying property in the year you place the property in service so it is separate from your depreciation deduction you can see chapter two of publication nine four six for more information about claiming this deduction then we've got the alternative minimum tax the AMT so if you use accelerated depreciation you may be subject to AMT alternative minimum tax accelerated depreciation like a double declining method kind of system allows you to deduct more depreciation earlier in the recovery period then you could deduct using a straight line method same deduction each year so in other words you have more deduction on the front end than the back end most of the makers depreciation for like equipment is a double declining kind of balance in that way not a straight line method so the prescribed appreciation methods for rental real estate aren't accelerated so with real estate usually you're you're using the straight line kind of system so depreciation deduction isn't adjusted for the AMT in other words if you used an accelerated depreciation you might be more likely to be subject to the AMT however at this point in time generally the tax code is going to basically require you most of the time to be using like a straight line method not an accelerated method for the depreciation however accelerated methods are generally used for other property connected with rental activities for example appliances and wall to wall carpeting so that kind of stuff might have might have accelerated depreciation methods alright so to find out if you are subject to the AMT see the instructions for form 6251 so the basics the following section discusses the information you will need to have about the rental property and the decisions to be made before figuring your depreciation deduction what rental property can be depreciated you can depreciate your property if it meets all the following requirements you own the property so obviously it's your property you're not renting it you use the property in your business or income producing activity such as rental property so you're using the property not for personal use you're not living in it or not the rental part of it at least you're renting it you're trying to generate revenue with it so the property has a determinable use full life so you can see how long it's going to be living for if it's rental property you're typically going to get that from the tax code the property is expected to last more than one year which of course you would expect to be the case if it was rental property property you own so what does that mean to claim depreciation you must usually be the owner of the property you are considered to be the owner of the property even if it's subject to debt so that gets back to that statement again of people saying I don't own the property the bank owns the property that's not technically true that's not technically true you took out a loan with the bank so that you can get the capital to buy the property and the property is basically collateral if you default on the loan the bank is not sitting at the kitchen table the bank has no say with their 80% of the property value loan that you have to tell you what color to paint the living room or anything like that so you have you have those two things are basically separate so you own the property even if you have debt out with it all right rented property generally if you pay rent for property you can't depreciate the property usually only the owner can depreciate it however if you make permanent improvements to lease property you may be able to depreciate the improvements so in other words if you rent the property if you're renting it then you can't take like like if I'm in a business or something like that and and I and I rent my office my office space well I can't take I can't take the depreciation on the office space because I don't own the office space I can take the rent on the office space however if I purchase the office space then then you expect I wouldn't have any rent but I would have the ownership of the building that I own it now and I would be depreciating the building as opposed to having the rent now if I rent the building and then I make substantial improvements to the building subject to to improve it to my specifications then maybe even though I'm renting the building I might be able to depreciate those kind of improvements or something like that alright see additions to improvements to property later in this chapter under recovery periods under GDS corporative apartments so if you are a tenant stockholder in a corporative housing corporation and rent your corporative apartment to others you can depreciate your stock in the corporation so C chapter 4 property having a determinable useful life to be depreciated your property must have a determinable useful life so this means that it must be something that wears out decays gets used up becomes obsolete or loses its value from natural causes so when we think about most things that we depreciate that is the case right because if you depreciate a piece of equipment you depreciate a forklift you depreciate you know those those things are going to go down in value when you talk about a building the building goes down in value it deteriorates over time although the land it's sitting on at least in terms of human timeframes doesn't really go down in value doesn't the dirt doesn't become more dirty it doesn't deteriorate down beyond that point in time and human life spans therefore we depreciate the building generally not the land it becomes important then to be breaking out the cost of the property we we have between the building and the land and again we have this weird dynamic with the real estate that we're hoping that although the building will deteriorate over time and the land is is what it is it's not going to go up or down in terms of its its deterioration over human life spans that the property itself might go up due to due to more people or something like that or due to whatever location location location right which is that weird dynamic we don't have most times with other depreciable property so what rental property can't be depreciated certain property can't be depreciated this includes land and certain accepted property so note that some property can't be depreciated so when we buy the real estate we have to break out between building and land which is an important breakout because the building is something we can depreciate the land isn't when you buy property you might be saying hey look I don't buy the property and buy the land and then pay a separate write a separate check for the building that's not how it's done it's a package deal how am I going to do that well you might look at the property taxes or something a format to break it out but we have to have some method to break it out because the property on the books is going to have land which is not depreciable building is depreciable from our perspective what do we want we want to allocate the cost to lower the taxes so I want to expense it in the current time frame if I can to get as big an expense as I can but they won't let me do that I have to put it on the books as an asset okay if I'm going to put it on the books as an asset I want to depreciate it as soon as I can to get the benefit as soon as I can but the land they're not going to let me depreciate it at all I'm not going to get the cost of now I'm not going to get a benefit from it until I sell it at which point it'll lower the amount of gain or increase the amount of loss on the sales price but the building at least I get to depreciate that over a long extended period of time and that'll be a benefit for taxes therefore and the taxpayer perspective we have an incentive to try to overpopulate you know the the amount of the allocation to the building which we're going to get a sooner tax benefit from then the land so we got to be careful we have it's an estimate so we want to make sure that we have a proper estimate but you can see where the incentives lie it would be incentivizing us to try to over estimate the building side to the land side all right land you can't you can't depreciate the cost of land because land generally doesn't wear out become obsolete or get used up but if it does the loss is is accounted for upon disposition so the cost of clearing grading planting and landscaping are usually all part of the cost of land and can't be depreciated you may however be able to depreciate certain land preparation costs if the cost are so closely associated with other depreciable property that you can determine a life for them along with the life of the associated property all right example example example you build a new house to use use as a rental and paid for for guard for grading clearing and seeding and planting bushes and trees some of the bushes and trees were planted right next to the house while others were planted around the outer border of the lot so if you placed the house you would have to destroy the you if you replaced the house you would have to destroy the bushes trees right next to it so now you paid for this landscaping stuff but the land it's right next to the building and therefore its life is going to be contingent on keeping the building in place so these bushes and trees are closely associated with the house so they have a determinable useful life therefore you can depreciate them add your other land preparation costs to the basis of your land because they have no determinable life and you can't depreciate them so add your other land preparation costs to the basis of your land because they have no determinable life and you can't depreciate them okay accepted property even if the property meets all the requirements listed earlier under what rental property can be depreciated you can't depreciate the following property so property placed in service and disposed of or taken out of business use in the same year that would be an unusual situation you would expect something funny would be going on if that happened equipment used to build capital improvements so you must add otherwise allowable depreciation on the equipment during the period of construction to the basis of your improvements in other words if you're actually building the building it gets a little bit confusing because now you're not just buying the building the cost the building isn't just the cost you're constructing the building and the stuff that was used to construct the building is you would think something that has to be not expense but rather be accumulated as the cost of the building so for more information see chapter 1 of publication 946 on that when does depreciation begin and end you begin to depreciate your rental property when you place it in service for the production of income when you start to use the stuff so you stop depreciating it either when you have fully recovered your cost or other basis or when you retire it from service whichever happens first so clearly if we're looking at property here what we're trying to do is generate revenue with it so when we place it in service to help us to generate revenue you would think that's when the depreciation would be you know starting on it we stop the depreciation when it's been fully recovered if we're talking about some type of rental property that the depreciation period is going to be a long time so if we bought it for $100,000 then we can't get the benefit of the deduction up front we want the depreciation as soon as possible we'll typically have to have a straight line depreciation once that $100,000 has been fully allocated through depreciation we can no longer depreciated because now we have allocated the cost fully if we further depreciated it our adjusted basis would be negative which shouldn't theoretically be possible or we might retire the property meaning sell it most likely before it's been fully depreciated at which point in time we stop depreciating it and we take the undepreciated portion the adjusted cost the adjusted basis into consideration to calculate the gain or the loss the lower the basis is in the property after we've depreciated it the more likely we're going to have a gain which will have a negative tax implication the higher the depreciation is the adjusted basis I mean is at the time we sell it then the more likely is it is that we're going to have a lesser of a gain which would be good for taxes or a greater loss which could be good for taxes so placed in service you place property in service in a rental activity when it is ready and available for a specific use in that activity so you might say well what look I placed it in service to rent but I don't have anybody in it yet but I'm totally trying to get someone in there or something like that so there's questions in terms of what does it exactly mean when you're placed it in service so even if you aren't using the property it is in service when it is ready and available for its specific use example one on November 22nd of last year you purchased a dishwasher for your rental property the appliance was delivered on December 7th but wasn't installed and ready for use until January 3rd of this year because the dishwasher wasn't ready for use last year it isn't considered placed in service until this year it's like no I bought it at the end of the year cause I wanted to get the depreciation in last year November and now they won't let me do it because it wasn't ready to go yet those dang installers cost me anyways if the appliance had been installed and ready for use when it was delivered in December of last year it would have been considered placed in service in December those dang installers messed it all up messed up my whole cost me taxes so even if it wasn't actually used until this year okay example 2 on April 6th you purchased a house to use as residential rental property you made extensive repairs to the house and had it ready for rent on July 5th so you begin to advertise the house for rent on July or in July and actually rented it beginning September 1st so the house is considered placed in service in July even though there's no one in it until September when it was ready and available for rent so you can begin depreciating the house in July example 3 you moved from your home in July during August and September you made several repairs to the house so on October 1st you listed the property for rent with a real estate company which rented it on December 1st the property is considered placed in service on October 1st the date when it was available for rent even though no one was in it yet at that point in time it was ready to go conversion to business use now we have some unique problems with regards to a conversion because I mean if you think about how you're going to acquire the rental property the rental property either you buy rental property which is pretty straightforward with determining the basis because that's basically going to start in essence the cost of the property and everything that was involved in purchasing the property you can build the property so you might buy a piece of land and then you have to take off whatever is on the land and then build a building on top of it which gets quite different of a scenario because then everything that you did to build up the building and what not has to be calculated as part of the building and then all the stuff you had to do the land to prep it is part of the land and so on so that would be a construction situation however you may have already owned the property for personal use like your house or something and then you're going to move or something like that and convert it from personal to rental property in that case the problem is that you don't know exactly what the basis is because your personal property your house although you get to deduct on schedule A the mortgage interest and the real estate taxes you haven't been depreciating over time because you don't get a benefit from depreciating because it's a personal property so you don't really have an adjusted basis at this point in time and the value of the house has changed over time because of circumstances so what is going to be the basis of the property when you put it on the books for rental property alright if you place property in service and a personal activity you can't claim depreciation so if it's personal you can't do the depreciation you don't depreciate your home you might get a benefit from the interest of the property taxes which is strange because it's personal stuff and not business related but that's how it is so that kind of confuses things so however if you change the properties used to business or the production of income you can begin to depreciate it at the time of the change so you place the property in service for business or income producing use on the date of the change so example you put it on the house and use it as your personal home several years before you converted it to the rental property although its specific use was personal and no depreciation was allowable you placed the home in service when you began using it as your home so you began to claim depreciation in the year you converted it to rental property because at that time it's used changed to the production of income so you changed it from the personal to the production of income logistically you have an issue there of what's going to be the basis in the property since I purchased it a while back kind of thing but I will dive into that possibly in future presentations