 Income tax 2022-2023, depreciation of rental property basics part number two. 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 tax year 2022. You can find it on the IRS website, irs.gov, irs.gov, looking at the support accounting instruction by clicking the link below, giving you a free 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. Income tax formula, we're focused online. One income, remember in the first half of the income tax formula is in essence and income statement, but just an outline. Other forms and schedules flowing into these line items, one of those, the Schedule E. It basically being an income statement in and of itself with rental income minus rental expenses. The net rental income flowing into line one income of our income tax formula. So in a prior presentation, we've been talking about depreciation related to the rental property. Quick recap here. Remember that depreciation is going to be one of the major type of expenses with regards to the rental property. And even if we have the rental property bookkeeping system on a cash based system, we're going to be required to do this a cruel type of thing. Putting the asset of the property on the books as an asset and then allocating the cost over its useful life in the form of depreciation. Also remember that our objective on the taxpayer side is to pay as little taxes as possible, which usually means we would rather get the cost or deduction sooner rather than later. So we from our perspective would like to say, I would like to get the expense when I paid for it, when I bought the property or something like that. If I could, the tax code says no, you got to put it on the books as an asset. And then when it's on the books as an asset, we would like to be able to get the depreciation expense sooner rather than later if we could, which means we would like to have lesser or smaller, less timeframe that it's going to be depreciated over the life of the depreciation. And we would like to have an accelerated method of depreciation, like double declining versus straight line, if possible. And of course, we're going to be subject, however, to what the tax code is going to be requiring us to depreciate. The tax code has to be quite stringent, given the fact that the incentives for taxes are a little bit different than they would be for a bookkeeping type of scenario. Okay, so idle property. So to continue to claim a deduction for depreciation on property used in your rental activity, even if it is temporarily idle, not in use. So we've been talking about the idea of when can we depreciate something? We're going to be depreciating it when it's being used in order to generate revenue. So there's a question of once one, when do I start depreciating it? Even if it's not completely in use at that point in time, I might have been trying to rent it, for example, and you would think once it's ready for use, then you could start depreciating it was the general idea as opposed to having to have someone actually in it at the point in time before you could start depreciating it. And if you have idle property, you would think a similar concept would be in play here. If it's idle, it's not in use, that might not be your fault. And it's not that you're not intending to use it to generate revenue. Idleness, not having it being less efficient in terms of the use of the assets is part of business. So for example, if you must make repairs after a tenant moves out, you still depreciate the rental property during the time it isn't available for rent. So a tenant moves out, you've got no one in the property. And even if you're not putting it out there to be rented, then you would say, well, it's still, you're still fixing it. So it's idle. You're not, no one's in it at that point in time, but you are preparing it for the rental use and it's already been in rental use. And then you're going to put it back on the market. So cost or other basis fully recovered. You must stop depreciating property when the total of your yearly depreciation deductions equal your cost or other basis of your property. So if you have a hundred thousand dollar building that you're depreciating and you've been depreciating it for many years, and now you've fully depreciated your depreciation expense over those many years adds up to 100,000. The basis or cost of the building, you cannot further depreciate it because that would take the basis down below zero. You have you have fully allocated the cost. Does that mean that the building is necessarily no longer in use? No, because depreciation is just an estimate. It's an allocation of the cost over an estimated useful life. So for this purpose, your yearly depreciation deductions include any depreciation that you were allowed to claim. Even if you didn't claim it, see basis of depreciable property later. Retired from service. Yes, stop depreciating property when you retire it from service. So retiring from service might be selling it or disposing of it in some way. Typically, if it was rental property, you would expect retiring it from service would be selling it or possibly converting it to personal use or something like that. So once again, you stop depreciating property when you retire it from service, even if you have fully recovered its cost or other basis. Even if you haven't fully recovered its cost or basis. So say you got that $100,000 building, you've been depreciating it. It still has an adjusted basis. You've only depreciated, you know, 60,000. It still has 40,000 of unadjusted, un depreciated costs, which would basically be the adjusted basis for it. When you retire it, you're taking it out of use or income generation possibly by selling it or converting it to personal use or something like that. If it was a sale at that point in time, for example, you might get the benefit from the sales price, meaning when you sell it, you're going to calculate the gain. The sales price minus the adjusted basis that hasn't been depreciated and the lower the gain, the better for taxes or it might increase the loss. A loss is actually good for taxes. So you retire property from service when you permanently withdraw it from use in a trader business or from use in the production of income because of any of the following events. So you sell or exchange the property. So that's probably the most common kind of scenario. We had rental property and now we're going to sell or exchange it. So you convert the property to personal use. So now you had rental property in retirement. Maybe you've got like five rental properties or something like that. And your retirement plan is that you're going to live in each of the rental property just long enough so that it gets you that massive exemption of your personal use of the home and then move into the other rental property converting it from rental property to personal home property or something. Some weird scenarios such as that you abandoned the property. So if you just walk away from the property, hopefully that doesn't happen. But that did happen a lot when we had the housing loan bubble and whatnot and the loan was greater than the value of the homes. So the property is destroyed. All right, depreciation depreciation methods. So generally you must use the modified accelerated cost recovery system. That's a maker's depreciation method common kind of term sounds intimidating. But we're generally just using normal conventions from like accounting depreciation like straight line as your baseline depreciation. And then we can convert from that to double declining or something like that. And we throw in half your conventions and that kind of stuff. So it's there's nothing really new from accounting. It's just trying to be more stringent in terms of exactly what we need to be depreciating as opposed to an accounting world. We have a little bit more flexibility to depreciate and choose the methods we think are most accurate for reporting purposes. Why would that be the case? Because for accounting, our goal is to be as accurate and as possible so that we can be as honest as possible to third party providers who will then want to do business with us. Given our transparency, you know that we want to have honest financial statements for taxes. We just want to reduce our taxes, right? So so so that means that the tax cuts got to be quite strict in terms of the what what methods they're going to force us to use basically. So we have the makers to depreciate residential rental property placed in service after 1986. So that's a key kind of cut off date. So if you placed rental property in service before 1987, you are using one of the following methods. So this would be again before 1987. Then you would have the accelerated cost recovery system, ACRS for property placed in service after 1980, but before 1987. And you've got the straight line or declining balance method over the useful life of property placed in service before 1981. All right, rental property placed in service before 2022 continue to use the same method of figuring depreciation that you used in the past. So we have this similar kind of consistency principle with depreciation, which of course would make sense. It gets quite confusing if you're saying I was using a double declining method and now the tax code is going to change it to straight line. Even though I'm like five years five years into a 30 year life property or something like that. So use use of real property changed. So generally, you must use makers to depreciate real property that you acquired for personal use before 1987 and changed to business use or income producing use after 1986. This includes your residence that you changed to rental use. So see property owned or used in 1986 and chapter one of publication 946 for those situations in which makers isn't allowed. So improvements made after 1986 treat and improvement made after 1986 to property you placed in service before 1987 as separate depreciable property. So now when we improve the property, we run into the situation of is it a repair or is it something I have to put it on the books as an asset? We on the taxpayer side of things would like to expense it when we do it as a repair or just an expense. But if it's an improvement, we have to put it on the books as an improvement. So we're not going to typically put it on the books and increase the basis of the building itself, but put it on and listed as a separate piece of property typically. And then the question is, well, how am I going to depreciate it? Given the fact that the depreciation methods for the real estate kind of have changed if I had real estate that I purchased at a later date versus a prior date. So once again, treat and improvement made after 1986 to property you placed in service before 1987 as separate depreciable property. As a result, you can depreciate that improvement as separate property under makers if it is the type of property that otherwise qualifies for makers depreciation. So in other words, usually you use the same method as the property that you that you put on the books, the residential rental property. But that residential rental property had really changed to what you would be recording it had if you put it on the books in the current timeframe rather than the past. So can I use the current method, which is the makers method or do I have to use the prior method? So for more information about improvements, you can see additions or improvements to property later in this chapter under recovery periods under GDS. So basis of depreciation property. So it's kind of like the adjusted cost, the basis key term. The basis of property used in a rental activity is generally it's adjusted basis when you place it in service in that activity. This is its cost or other basis when you acquire it adjusted for certain items occurring before you place it in service in the rental activity. So when you when you buy the property, if you're buying it and putting it into rental property use, then you would think it's the cost and the things that were put in place in order to get it ready for rental property use would be fairly straightforward in terms of what would be included as the cost, which in essence would be the basis in that case. It gets a little bit weird when you get the property in another way, such as you converted it from personal, you inherited it or you converted it or something like that. So if you depreciate your property or you built it, that's what I was trying to spit out, you make it, you construct it. So if you depreciate your property under makers, you may also have to reduce your basis by certain deductions and credits with respect to the property. So basis and adjusted basis are explained in the following discussion. So caution, if you use the property for personal purposes before changing it to rental use, its basis for depreciation is the lesser of. So here's the other situation, you didn't buy it, you bought it a while ago possibly for personal use, now you're converting it. The fair market value is no longer what it was when you purchased it. When you purchased it, the fair market value was the cost because, assumedly, in an arm's length transaction, you paid the fair market value for it. But now, if you were to have sold it, the fair market value would be different. So what should be the basis when you convert it from personal to business? So once again, if you use the property for personal purposes before changing it to rental use, its basis for depreciation is the lesser of its adjusted basis or its fair market value when you change it to rental use. So see basis of property change to rental use in Chapter 4. All right, cost basis. The cost basis of property you buy is usually its cost. The cost is the amount you pay for it in cash in debt obligation and in other property or in service. So when you buy the property, you might have paid cash for it. You might have took out a loan and paid for it or you might have given other property or you might have given other services for it. No matter what the format is, that's going to be included in the cost. So if the building cost $100,000 and you paid them cash of $100,000, obviously that's the basis. If you paid them cash of $20,000, you took out a loan of $80,000 and you still paid them $100,000, but now you have a loan of $80,000. You still bought it for $100,000, which would be the cost. If you traded property for it, I mean, or if you gave property for it, I'm not talking exchange, but you gave something other than cash, gets a little bit more confusing because then you have to calculate or figure what the value of the property was. But you still paid them an equivalent, let's say of the same $100,000, just not with cash. Or if you gave them services, again, the idea would be that you still gave them value of $100,000, even if it wasn't cash. So sales tax charged on the purchase, but see exceptions. So the sales tax would oftentimes be in the cost or basis, but there could be exceptions. Note that sales tax is one of those things that could be deductible in the Schedule A sometimes, depending on what method, if you live in a state that has sales tax or income tax, so that can get a little bit messy. Frate charges to attain the property, so any freight charges are going to be included in the cost if they're there. Installation and testing charges, so if it's something that you're installing or something like that, then the installation and testing are part of what was necessary to get the thing up and running for use and therefore not expense, but rather you have to put them on the books as the cost of it. So exception, if you deducted state and local general sales taxes as an itemized deduction on Schedule A Form 1040, you don't include as part of your cost basis the sales tax you deducted. So there's that funny sales tax thing, which will be dependent on what state you're in and whether or not you're taking the sales tax on a Schedule A, if they have a Schedule A, if they're itemizing as opposed to taking the standard deduction. Such taxes were deducted before 1987 and after 2003, so loans with low or no interest. So if you buy property on any payment plan that charges litter or no interest, the basis of your property is your stated purchase price less the amount considered to be unstated interest. So in other words, obviously if you bought a hundred thousand dollar building or piece of real estate and then you took out a loan for 80,000, the loan is going to be structured in such a way that you're going to have to pay interest on the loan if you buy it from if you get the loan from a financial institution, but if you get the loan from something other than a big financial institution, you can imagine many different loan structures that can be kind of unusual and if the loan isn't charging interest, then that's not really a real loan because interest has to be in there somewhere because there's going to be time value of money considerations that are in play. If you're not including interest over a 30 year loan of like $80,000, then what you really did is just adjust the price of the loan like the loan terms have been adjusted. So you have to impute the interest or kind of figure what an arm's length transaction would be in that case. So because otherwise it doesn't make sense, you know, so anything. See unstated interest and original issue discount OID and publication 537 installment sale. So real property. So if you buy real property such as building and land, certain fees and other expenses you pay are part of your cost basis in the property. So you might have all these other fees that are going to go into place other than just what was stated as the cost of the property and all that kind of stuff because it was part of the purchasing process. You might have legal fees and that kind of stuff and you might be and obviously from the taxpayer perspective, we would say I would like to expense all that stuff in the year I paid for it. And the IRS is going to say, well, no, you had all that stuff you in order to purchase the building. So you have to include it in the cost of the building and then you have to depreciated over whatever forever instead of getting the expense up front. All right, real estate taxes. If you buy real property and agree to pay real estate taxes on it that were owed by the seller and the seller doesn't reimburse you, the taxes you pay are treated as part of your basis in the property. So then we get into all this kind of situation when the property is like an escrow or something like that. And there's taxes owed on it or something. Then those taxes are really the taxes owed by the seller of the property when you're buying the property because the taxes weren't incurred when you were in ownership of the property. But if you pay for those taxes, then again, you're in this situation. We would like to say, well, yeah, I paid for the taxes. I should be able to deduct the taxes when I paid them. But they weren't really taxes that were incurred when you owned the property. They were actually taxes. So they're really part of the sales price because this is just part of the negotiation process of the sales price. So you have to include it in the cost. And that means that you're going to have to depreciate that component over a long time as part of the cost. You can't deduct them as taxes paid. So if you reimburse the seller for real estate taxes, the seller paid for you, you can usually deduct that amount. Don't include that amount in your basis in the property. OK, settlement fees and other costs. The following settlement fees and closing costs for buying the property are part of your basis in the property. So all the stuff that is kind of part of the process of buying the property generally can't be expense at the point in time that you buy it, but rather included in the cost or basis so that you're going to have to depreciate over the useful life. Abstract fees. Charges for installing utility services. Legal fees. Recording fees. Surveys. Transfer taxes. Now, obviously some of these like legal fees, for example, these are legal fees specific to purchasing the property. Other legal fees for lawsuits or whatever else you got going on. You can deduct those, most likely. But the legal fees that are necessary to buy the property need to be included in the basis. Title insurance. Any amounts the seller owes that you agree to pay such as back taxes or interest recording of mortgage fees, charges for improvements or repairs and sales commissions. The following are settlement fees and closing costs you can't include in your basis in the property. So we have one fire insurance premiums to rent or other charges related to the occupancy of the property before closing. The three charges connected with with getting or refinancing a loan such as a points, discount points, loan organization fees, B loan assumption fees, C cost of the credit report and D fees for an appraisal acquired by a lender. Also, don't include amounts placed in the escrow for the future payment of items such as taxes and insurance. So if you're not including these items in the cost, then you might be able to, if their business expenses, deduct them when they happen. So like the insurance may be able to deduct the insurance, although you have that prepayment kind of situation, rent or other charges related to occupancy of the property before closing. The points kind of situation usually has to do with the interest. So you may still have to put it on the books and depreciate it, but not as the cost of the building, but possibly put it on the books and depreciated over the life of the loan that we talked about in a prior presentation a bit. Okay, assumption of a mortgage. If you buy property and become liable for an existing mortgage on the property, your basis is the amount you pay for the property plus the amount remaining to be paid on the mortgage. So usually what happens is you've got someone selling the property and you're buying the property. The person selling the property is selling the property for the cost, let's say of $100,000 and they have, let's say a $40,000 loan that's still outstanding on the property. Usually what happens is when you buy the property, you say, okay, I'm going to give you $100,000 and I'm going to take out a loan of 80% and then cash 20,000, 80,000 of a loan and pay you 100,000, the person that sold the property is going to take the 100,000, pay off their $40,000 loan and they're gone. So now you have two loans, one got paid off and one was set up. But you can imagine the situation, why don't I just assume the loan of the person that's selling it, right? In that case, so now you're just going to assume their loan. Well, if it was a $100,000 property and there was a 40,000 loan that is being assumed, you're still basically buying it for 100,000. But now you're basically assuming their loan of the 40,000 when you purchase it. So you would think the basis would still be like an example. You buy a building for 60,000 cash and assume the mortgage of 240,000 on it. So you assume their mortgage, you're still in a similar situation as if you took out the loan, a new loan. So your basis is 300,000. So instead of having a 300,000, taking out your own loan of 240,000 and then paying the other guy the full 300,000 and they pay off their loan. You just assumed their loan, but you're kind of in the same situation in that the cost would be 300,000. You got a loan of 240,000. Okay, separating cost of land and building. If you buy building and your cost includes the cost of the land on which they stand, you must divide the cost between the land and the building to figure the basis for depreciation of the building. So we talked a little bit about this in a prior presentation. Note, you're buying a package deal, land and building, one lump sum cost usually. But you need to break out between land and building. Somehow, possibly you can use like the property tax statements sometimes have a breakout of that. We tend to want to, from the taxpayer perspective, overstate the land portion to the building portion because we get to depreciate the land portion, which is a benefit for taxes. But obviously you have to do it in a fair breakout. It's going to be some kind of estimate though between land and building. The part of the cost that you allocate to each asset. All rights to specified assets. It is the ratio of the fair market value of that asset to the fair market value of the whole property at the time you buy it. So if you aren't certain of the fair market values of the land and the buildings, you can divide the cost between them based on their assessed values for real estate tax purposes. So real estate taxes, it's kind of like the default because the taxes are going to use that kind of estimate. So oftentimes that's a useful place to go. Example, you buy a house and had land for $200,000. The purchase contract doesn't specify how much of the purchase price is for the house and how much it's for the land. So the latest real estate tax assessment on the property was based on an assessed value of $160,000, of which $136,000 was for the house and $24,000 was for the land. So now I can take a ratio of that. We can say you can allocate 85%, which is the 136, because notice the problem here. When the assessment, the tax assessment happened, it was at a different price than what we purchased the land for. But I can use the ratio of the last assessment to do my allocation. So then I got to say, okay, 136,000 divided by the 160,000 is 85% of the purchase price to the house and 24,000 divided by 160 or the other 15% is going to be going to the land. So your basis in the house is 170,000, which is 85% of now the price. Not 160, but we purchased it for 200,000, 170,000, and your basis in the land is 30% or 15% of the 200,000. Okay, basis other than cost, you can't use cost as a basis for property that you received in return for services you performed in an exchange for other property as a gift from your spouse or from your former spouse as the result of a divorce or as inheritance. These things kind of mess things up, right? If you exchange the property in like a 1031 exchange, then you have this basis issue, what's going to be the basis in the exchange and that gets into a whole thing in and of itself. If it was a gift, well, now you got the property for free. Is your basis zero in the property or we're going to allocate the basis of the person that gifted it or something like that would be reasonable. If it was an inheritance, well, then what's the basis in the property? Again, you got it for nothing. And the person that died might have had to pay death taxes on it or something, a state taxes. So and obviously in the divorce situation, the price isn't an arm's length transaction either. So if you receive property in one of these ways, you could see publication 551 for information on how to figure your basis. So those get into common, but more kind of confusing situations, which you have to go into specific scenarios related to them to get to your basis or an adjusted basis. To figure your property's basis for depreciation, you may have to make certain adjustments, increases and decreases to the basis of the property for events occurring between the time you acquire the property and the time you place it in service for business or the production of income. So now you buy the property, but it's not ready to roll. You don't have it servicing at that point in time. So we're not yet depreciating it. And we might have some more costs that we're putting into it in order to get it ready for us to make money with it. So in that stuff that we put into it, we would have to include into the basis. The biggest example would be like if you bought a piece of land and you actually built the entire building, you constructed it. Everything you did to construct the building, in essence, wouldn't wouldn't generally be expense, but rather would be part of the construction of the building, part of the cost or basis of the building that you would then depreciate once you start renting it. So the result of these adjustments to the basis is the adjusted basis. So increases the basis. You must increase the basis of any property by the cost of all items properly added to a capital account. These include the following. The cost of any additions or improvements made before placing your property into service as a rental that have a useful life of more than one year. Amounts spent after a casualty to restore the damaged property. The cost of extending utility service lines to the property. Legal fees such as the cost of defending and perfecting title or settling zoning issues. Additions or improvements. Add to the basis of your property the amount of an addition or improvement actually costs you, including any amount you borrowed to make the addition or improvement. This includes all direct costs such as materials and labor, but doesn't include your own labor. It also includes expenses related to the addition or improvements. So when you're adding to the property then or if you're building something or improving the property, then what's going into it, you might think, well, it should just be materials is what comes to most people mind. But obviously the labor that's being put into place is being used to construct an asset and therefore should be included in the value of the asset, not, you know, expense. So you're, you're, for example, if you had an architect draw up plans for remodeling your property, the architect's fee is a part of the cost of the remodeling. Or if you had your lot surveyed to put up a fence, the cost of the survey is a part of the cost of the fence. So keep separate accounts for depreciable additions or improvements made after you placed the property in service in your rental activity for information on depreciation additions or improvements. See additions or improvements to property later in this chapter under recovery periods under GDS. Assessments for local improvements. Assessment for items which tend to increase the value of property such as streets and sidewalks must be added to the basis of the property. For example, if your city installs curbing on the street in front of your house and assesses you and your neighbors for its cost, you must add the assessment, assessment to the basis of your property. Also add the cost of legal fees paid to obtain a decrease in an assessment levied against property to pay for local improvements. You can't deduct these items as taxes or depreciate them. However, you can deduct assessments for the purpose of maintaining or repairs or for the purpose of meeting interest charges related to the improvements. Don't add them to your basis in the property. All right, deducting versus capitalizing costs don't add to your basis costs. You can deduct as current expenses. So clearly you can't have a cost that you're going to expense and include in the basis of the property. That would be a form of double dipping, getting the expense in the current time frame as well as the expense over the useful life in the form of depreciation. However, there are certain costs you can choose either to deduct or to capitalize. If you capitalize these costs, include them in your basis. If you deduct them, don't include them in your basis. The costs you may choose to deduct or capitalize include carrying charges such as interest and taxes that you must pay to own property for more information about deducting or capitalizing costs and how to make the election. See carrying charges in Chapter 7, Publication 535 decreases to basis. You must decrease the basis of your property by any items that represent a return of your cost. These include the following. Insurance or other payments you receive as the result of a casualty or theft loss. So if you got reimbursed then it shouldn't and you were going to include the item in the cost and then you got reimbursed. Well, that's not going to be a cost to you. Casualty loss not covered by insurance for which you took a deduction. So if you took a deduction, then you're not going to include it in the basis because you got the benefit in the form of a deduction amounts. Amounts you receive for granting and easement residential energy credits. You were allowed before 1986 or after 2005 if you added the cost of the energy items to the basis of your home exclusion from income of subsidies for energy conservation measures. Special depreciation allowance or a Section 179 deduction claimed on qualified property depreciation you deducted or could have deducted on your tax return under the method of depreciation you chose. That would be like one of the most common ones, right? Because the basis is the cost and then you're going to get the benefit of the cost not in the year you purchased it with an expense at that time. But depreciating it as you depreciate it, you're lowering the basis and you're lowering the potential tax benefit as the adjusted basis goes down. So if you if you didn't deduct enough or deducted too much in any year see depreciation under decreases to basis in Publication 551. So if your rental property was previously used as your main home you must also decrease the basis by the following. Gain you postpone from the sale of your main home before May 7, 1997 if the replacement home was converted to your rental property. The District of Columbia first time home buyer credit allowed on the purchase of your main home after August 4, 1997 and before January 1, 2012 amount of qualified principal residents indebtedness discharged on or after January 1, 2007. So this first one is probably like the most common one. You would think that if you if you purchased the home for like a hundred thousand dollars and then when you convert it to rental property, it's now worth a hundred and fifty thousand dollars. You had a gain of fifty thousand dollars. You're not realizing the gain at the point of conversion from personal to rental property. And if you were to be allowed to put the property on the books at a hundred and fifty thousand you would have got what we call like a step up in basis of fifty thousand allowing you to be able to depreciate now and added fifty thousand which would be good for taxes. But so generally you would think that wouldn't be fair to do. Instead you would think that you would have to put it on the books for the lesser of as we saw the fair market value or the cost in this case the cost would be lesser of the hundred thousand. So you can only depreciate you know the hundred thousand and you might think well that's not that's not fair. You might think at first but but that seems to be reasonable given the fact that if you got the step up in basis you would have gotten like that tax-free step up in basis. And if you sell the property then it should even itself out because now the basis is at the lower basis and you're going to have to realize that fifty thousand of gain at the point in time that you sell it would be the general idea. Okay.