 Income tax 2021-2022, depreciation rental property part two. Get ready to get refunds to the max diving in the income tax 2021-2022. Most of this information can be found in publication 527 residential rental property tax year 2021 on the IRS website irs.gov irs.gov. Income tax formula focusing in on line one income. We would have a subschedule basically an income statement that has income and expenses. The net then is what rolls into line one income on the income tax formula as well as eventually page one of the form 1040. This is the schedule E basically the income statement schedule for the rental property. We're focusing in on the rental real estate for the schedule E the supplemental income and loss. So we're continuing on with the property. We're talking about what it means to be placed in service. Noting that when we have property and we start thinking about the depreciation that's going to be imposed on that property that will usually start at the point in time. It's going to be placed in service. So what does it mean then to be placed in service? You place property and service in a rental activity when it is ready and available for a specific use in that activity. Now note if you're talking about the actual property itself then like the rental property then obviously if you bought the rental property specifically for renting it. Then it's a pretty straightforward type of situation where you you know you not like changing the property to have a different use for it. But if you're building the property then it gets a little bit more complicated because now you've got the accruing of the costs that are accruing upwards until the point in time that you're actually ready to basically be renting it. And if you're converting property from some something else such as like a home principal home for example to rental property then you got to think about when that takes place as well. And then in that situation you also have to consider the basis of it which could be a little bit more confusing considering it's been personal use property up until that point in time. You didn't just buy it on the market you know at that point in time. So even if you aren't using the property it is in service when it is ready and available for its specific use. So if it's a rental property it's ready and it's available basically you've got it you're advertising for it you're trying to get people into the property even if it's that's when it's basically the depreciation you would think would be taking place. Let's take a look at some examples then example number one on November 22 of last year you purchased a dishwasher for your rental property. So that's you got the dishwasher the appliance was delivered on December 7 but wasn't installed and ready for use until January 3 of this year. So we bought it last year but it wasn't actually installed until the current year because the dishwasher wasn't ready for use. Last year it isn't considered placed in service until this year. So that would typically we wouldn't like that as much. First of all we got to capitalize the dishwasher instead of expensing it which is kind of a pain in the first place and then we didn't get it installed before December. And so it hasn't actually been in use and therefore we might have to wait until January to record it and get the benefit of the dishwasher for depreciation. So if the appliance have 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 even if it wasn't actually used until this year. Also just note that the dishwasher cost that we're going to capitalize may include the installation of the dishwasher because that was necessary in order to get the dishwasher ready for use as opposed to basically expensing possibly the activity of installing the dishwasher. You kind of got to be careful with what's included in like equipment as well that you have to then capitalize which we would rather not do we'd rather expense it right. So we got to think about what kind of things we have to capitalize what kind of things we have to expense and when does the capitalization period start and the general rules we're trying to do as in a legal purpose is trying to think about how can I get things to be categorized as expenses as opposed to being capitalized because I usually get better tax benefit and how can I get things you know rolling so I can take the depreciation earlier if I have to depreciate as the general idea of earlier is better than later that's the mindset that you're typically thinking of as a taxpayer when you're dealing with this tax code. So on April 6 you purchase a house this is example number two by the way on April 6 you purchase a house to use as residential rental property. You made extensive repairs to the house and had it ready for rent on July 5 so you begin to advertise the house for rent in July and actually rented it beginning in September. So the house is considered placed in service in July when it was ready and available for rent. So again we got three dates on April 6 you purchased it. So that's the first state and then you made repairs on it but it was ready in July. So when you purchased it it wasn't ready it wasn't ready to go. You had to fix it up and when you fixed it up you probably put improvements on it. So now when you're thinking about what has to be capitalized versus what gets to be expensed. You would think you purchased it and then the improvements might be something that you have to include in the basis the cost of the home or the cost of the building that you then would have to basically allocate as opposed to what you would like to do. That's what you got to kind of figure out do I get do I have to put it as capitalized or can I expense it to be ready for then its use which would be on July. So now it's ready to go. So whatever the basis is at that point in time that you had to include in the basis is when you would typically start to depreciate it even though you haven't yet rented it at that point in time because it's ready to go. You begin to advertise the house for rent in July. So that's good evidence. So if the IRS was to audit you and say hey you know how do you know it was ready to go at that point in time. Well you started advertising that some evidence that it's ready to go. I'm trying to get people in there. You know that's why I'm doing it. So so then the house is considered placed in service in July when it was ready even though you didn't get someone in there until September. Okay example number three you moved from your home in July during August and September you made several repairs to the home. So now you got your personal residence your home that you started out with on October 1st. You listed the property for rent with real estate company which rented it on December 1st. So now you got your home. It was your home possibly your primary residence and then you moved from your home in July so it's no longer your home you're going to rent it. So then you fixed it up. You're not renting it yet but then on October 1st you listed the property. The property is considered placed in service on October 1st the date when it was available for rent and that's when you might be able to start basically the depreciation when it was ready to go. Now that one again you got to think about also and we'll talk more about this later. But what's the basis of the property because it was personal property before that point in time. So I hadn't been really I hadn't been really depreciating anything prior to that right. So now you got to figure out you know the basis or the cost of it. You know at that point then you might have put improvements in on it when you got it set up for the rental property and so on. So now you got the point we're thinking about here is when do you start the depreciation. What we're going to think about later is what's the basis that you're going to be depreciating in that instance as well. So then we got the conversion to business use. If you place property in service in a personal activity you can't claim depreciation. So if you if you bought a home or something or it's your lake house or something like that and you're just hanging out there. You're just hanging there. You're not you're not renting it. It's not for business use. So you don't depreciate it. You don't appreciate your home because it's your home. You get to deduct mortgage interest and property taxes because that's weird. Like it's not follows the doesn't follow the normal rule of you expense stuff when it was used in order to generate revenue which is the natural rule that you would expect from an income tax. So so that's why it gets a little funny. You're like well I get to deduct this stuff but that's because it's weird most likely because a lobbyist or something in the housing area but you don't get to depreciate it at this point in time for your personal residence. However, if you change the properties used to business or or the production of income you can begin to depreciate it at the time of the change. So if you moved it from your personal home or whatever to rental property for example now it went from personal use which you don't usually get a deduction for to business use which you do typically get a deduction for. One of the biggest deductions you get with like rental property one of the biggest costs you have in order to generate the revenue is the purchase of the rental property. Now again that gets a little bit more confusing than other kinds of things like buying inventory for example to sell the inventory because we're trying to make in income on the rental property in a couple different ways one through the rent but to just in the increase in the value of the property. But in any case if it's a business thing that's when you would think you'd get to deduct stuff like depreciation so you place the property in service for business or income producing use on the date of the change example. You bought a house and use it as your personal home several years before you converted it to rental property so it's your home you lived in it it was beautiful it's a beautiful home but it's time to rent it now. Although it's specific use was personal and no depreciation was allowable you place the home in service you when you begin using it as your home. You can begin to claim depreciation in in your in the year you converted it to rental property because at that time it's used change to the production of income. So that's when you get to get to take the depreciation again you were saying before I got to deduct interest in property taxes yeah because that's weird. But under income taxes normally you have to it's got to be an income producing thing because then that's the expense that you needed to expand in order to generate the income so that your tax on net income as opposed to the gross income. So you have the same kind of problem there though of course is what's going to be the basis what's going to be the cost what's going to be the amount that I'm going to be depreciating and we'll talk about that later. So idle property continue to claim a deduction for depreciation on property used in your rental activity even if it is temporarily idle meaning nobody's in it it's not in use what do I do at that point I'm trying to rent it but no one's in it so it's still rental property because you're trying you're trying. For example, if you if you most make repairs after a tenant moves out you still depreciate the rental property during the time it isn't available for rent. So notice before when we were setting the property up to first put it into place first put it into service then we you know any repairs to get it ready for service. We didn't start that in the depreciation but once we're depreciating it and we had a tenant and they move out we don't we don't stop the rental process and say I'm not depreciating anymore for that time period. No it's part of the business activity at that point in time we're rolling the ball is rolling and it's going to continue to roll as business property so cost or other basis fully recovered. You must stop depreciating property when the total of your yearly depreciation duck deductions equals your cost or other basis of your property. So clearly that the depreciation represents the allocation of the cost or basis over the useful life or whatever time frame the government forces us to allocate it over. Once we've allocated the cost we cannot keep depreciating because then we would be depreciating past the actual cost we can't we if it costs 300,000 we can't depreciate 350,000 over the life of the home because it only cost us to 300 or whatever the basis of the homeless so once we fully depreciated it. Once the book value in essence once the cost minus the accumulated depreciation is zero we stopped depreciating but that's a pretty long time because they force us to depreciate it if it's rental property at least real estate for a long time 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 depreciation property later. So retired from service what if you're going to retire not you the how you're retiring the house from service it's been serving it's been serving diligently. But it's time to retire it the home that is so you stopped appreciating property when you retire it from service even if you haven't fully recovered its cost or other basis. So if you stop using it for the rental property or whatever, then you can't keep claiming the depreciation because you're no longer using it to generate income. You retire property from service when you permanently withdraw it from use in a trade or business or from use in production of income because of any of the following events you sell or exchange the property. You still kind of you might get a benefit like when you sell it of of the under so you so the problem here is you're saying okay I bought the property and now I didn't get to depreciate all of it so I didn't get all the benefit from the depreciation. It cost me 400,000 for example and I only depreciated 250,000 and now I'm going to sell the property but I didn't get to depreciate the other the other amount there that's still there. Well you still kind of get a benefit from that when you sell it because the basis will be higher when you depreciate it the basis like the book value kind of would go down. And then you'd have a bigger gain that you might have to report taxes on possibly in that event. But if you were to but so so that so the higher basis is going to be beneficial because when you depreciated the basis goes down, which means the gain could be higher. You do have this issue of whether or not something's going to be ordinary income taxes versus capital gain taxes and so on, which complicates matters as well if there's a difference between those two. But in any case, you convert the property to personal use that would be if you if you moved into it it was rental but then you moved into it. Then then now you've retired the property from the business use it did a good job but it's going to you're retiring your property and you're going to move into it and take care, take care of your home. You that was rental property before that so abandoned the property so if you just say okay we're done with this. I'm just move I'm just leaving the property is destroyed. So depreciation methods well how do we do this depreciation stuff you might be familiar with like a straight line method generally accepted accounting principle methods. The tax code is going to have its own methods they'll mirror to some degree general accounting principle methods, but you got to follow the tax code. So generally you must use the modified accelerated cost recovery system the MACRS to depreciate residential rental property placed in service after 1986. If you place rental property in service before 1987 you were using one of the following methods the accelerated cost recovery system otherwise known as acres ACRS for property placed in service after 1980 but before 1987. Straight line or declining balance method over the useful life of property placed in service before 1981 rental property placed in service before 2021. That's the tax you were currently thinking about so we're thinking tax year 2021 we placed it in service before that continued to use the same method of figuring depreciation that you used in the past. So in other words when you first put the property in place just started depreciating it. Normally you're going to be consistent and keep that depreciation method rolling going forward. So if we had on the books in the prior year we usually roll it forward that means when you first start the depreciation process when you first put the property on the books to depreciate it. Then you want to do it right the first time because that's going to set the precedent and hopefully everything will roll forward properly from there. So use real property changed. So what if it changed generally you must use makers to depreciate real property. That's the more current method if you were to have something in place in the current period. So generally you must use makers to depreciate real property that you acquired for personal use before. So now you had it for personal use because you weren't depreciating it when you had it for personal use because you don't depreciate it typically then and change to business or income producing use after 1986. So now you changed it after that point in time. So then you would have to use the method at that point. So this includes your residence that you changed to rental use. See property owned or used in 1986 in chapter one of publication 946 for those situations in which makers isn't allowed. So improvements made after 1986. So now you're talking about improvements. So you made improvements to the home. You've expanded on it in some way or something like that. You couldn't expense those items you had to put them on the books as an asset and depreciate them. So how are you going to depreciate the improvements treat an 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 you got the separate property. It's an improvement. So but you're going to put it on there kind of like a separate property instead of like adjusting the basis of the actual home itself on there with a real estate itself. And then you'll depreciate it in accordance with the makers rules. So for more information about improvements see additions and improvements to property later in this chapter under recovery periods under GDS caution. This publication discusses makers depreciation only if you need information about depreciating property placed in service before 1987. You could see publication 534 basis of depreciable property. The basis of property use in a rental activity is generally it's adjusted basis when you place it in service in that activity. So the adjusted basis is like the adjusted cost. You can basically kind of think of it because the cost in essence is what you're going to allocate. But it gets a bit confusing as to what the cost is because when you buy the thing you got it in its real estate. For example that gets that's the most confusing one typically because all the things that you had to do in order to get the real estate might be included in the cost. You got to make sure that you're picking up the proper amounts there and then it could be adjusted for things like improvements or something like that. So this is its cost or other basis when you acquire it adjusted for certain items occurring before you placed it in service in the rental activity. So if you bought it then you got it you got to deal with the cost related to the purchase right and then if you did anything else to it to get it ready for the rental process before you actually started the rental process. You would think that would be included in the basis kind of like the adjusted cost that you would then get a tax benefit from not by expensing it in the current year which would be a straight cash basis. Kind of method generally but an accrual method putting on the books as an asset depreciating it over the life that the IRS forces you to depreciate it over. 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 basis and adjusted basis are explained in the following discussion. So we'll get into that. It'll be great caution. If you use the property for personal purpose before changing it to rental use its basis for depreciation is the lesser of its adjusted basis or its fair market value when you changed it to the rental use. So now if you had something that as personal property like a home then you bought it now you got a difference between the market price when you purchased the home and the point in time that you used it for rental property. So now you've got your you still got your cost you're saying hey I still got my adjusted basis which in essence is what I purchased it for and then possibly any improvements I had on it before I used it to rental. But if I've been holding on to the home for you know 15 years or something it's quite possible that the market value is substantially different. So what do I use then do I use the adjusted basis what I paid for it and the improvements or do I use the market value at that point in time. From a taxpayer standpoint which one would you like to use the higher basis. I want to use whichever one's higher if it went up in value I want to use the higher one because I want to be able to depreciate the cost of of the property and and have a higher basis in the event that I sold it. Lowering the gain resulting in less tax that I would owe in that case. 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 we got the lesser of 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. rental use. So you could see basis of property changed to rental use in chapter four for more information about that. Cost basis. The basis of property you buy is usually its cost. So the basis is like another word you can think about it as like kind of the adjusted cost in essence. The cost is the amount you pay for it in cash in debt obligation in other property or in services. So however you paid for it you financed a lot of it most likely most people would on it that still means that you paid for it in some way and then you have a loan out that doesn't mean that doesn't mean you didn't pay for it with that amount. So you could pay for it with debt you could pay for it in some other way such as property for example. So your cost also includes amounts you pay for sales tax charged on the purchase. So now you're thinking about as you go through kind of like the purchase process it takes time to do that you might have like an escrow period or something like that that's going to go through and other charges that are going to go into play. Then you have the question do I get to what do I do with those other charges. Do I apply those to the cost of the home or can I expense those. Again we would rather typically expense them at that point in time if we were allowed to take the expense because then we get the deduction sooner as opposed to including them in the cost of the home capitalizing them in essence in which case we have to depreciate them along with the cost of the home over a very long time frame that the government is going to make us do that. But that's that's generally the way it's going to it's going to work. So you have the freight charges to obtain the property and installation and testing charges. So and that'll happen with real estate also when you're talking about other property like that washing machine we talked about earlier the installation charges the freight to get the stuff from wherever it was before to us we can't just expense the freight charges you might think well I could just expense the freight and I'm just going to put on the books the cost the washing machine but really the whole the cost to get it up and running and ready to go includes generally the freight that it cost to get there and then the installation cost. So exception if you deduct 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 taxes you deducted such taxes were deductible before 1987 and after 2003. So you got that kind of quirky thing with the sales tax. So that's the state tax on the schedule a and and you might in in that event if you're in a high cost of living state you might be taking like the income tax or you might have the option to take the sales tax and then if you take the sales tax then that kind of skews things a bit because you shouldn't get like the benefit of the sales tax on the schedule a you would think and then the benefit in some other way on the rental property not deducting the sales tax here but including it in the cost or basis which would still be a benefit. So you'd rather take it on the schedule a because you get the tax sooner if that would be a benefit there but it would still be a benefit you'd be double dipping in essence if you got both.