 Income tax 2021-2022, software example, depreciation of rental property. Get ready to get refunds to the max, dive into income tax 2021-2022. Lesser tax software, you don't need tax software to follow along, but you might want to have access to the forms and schedules, which you can find on the IRS website at irs.gov, irs.gov. Starting point here, we got the single filer Adam Smith Living in Beverly Hills 90210. Adam has some rental income flowing through to line number eight. Let's take a look at that flow through process. We got the schedule E, which is the supplemental income and loss. This is gonna be the property that is rental property in this instance. Then down below, we basically have an income statement, which we've kept quite simple at this point with the rents and that being the income, of course, for the rental property at the 120,000 and then one expense at the 20,000 that nets out to that net amount of the 100,000, which flows into the schedule one called the additional income and adjustments to income at the 100,000, that then flows in to page one of the form 1040, the place we started at, the eight line number eight, you recall, it wasn't that long ago, you probably remember. So this is gonna be the total income 100,000. We got the standard deduction at the 12,550. We've got the taxable income at the 87,450. Page number two, calculating the tax at the 15,015. Let's go back to page one. Let's go to schedule E and we're gonna add a bit of complication. That's gonna be with the depreciable type of assets. Now there's different types of depreciable assets that we could put on the book. The general idea is the same, that being, if something is a large kind of expenditure, it's gonna be benefiting multiple periods into the future, then we shouldn't be putting it on the books as simply an expense here, even if we paid cash for it, even if we're on a cash basis system for other kinds of transactions. This one's such a large deviation from a cash basis or from the time that we make the payment to the benefit that that expenditure is gonna be providing us, that the tax code forces us to use an accrual concept, that being a concept of depreciation, putting the asset on the books as an asset and then depreciating it. Now you'll note that we don't have a balance sheet on this schedule E. This is just an income statement. So how do I put it on the books as an asset? Well, we're not gonna have a balance sheet but we'll have another schedule which will be a depreciation schedule which will at least have that one asset and the detail behind it for the depreciation of it. So that's where we're gonna put it, that's gonna be the balance sheet account and then we'll pull it over here in terms of depreciation. Now what kind of things do we need to depreciate? Well, first of all, obviously the property itself. So even if we paid cash for the property which isn't often the case, we often finance the property but even if we were to have paid cash for the property, we're not gonna just expense the property because that's the biggest example of something that is the reason you have an accrual concept of putting it on the books as an asset. It would be a huge distortion to say, I'm gonna put the property on the first year of rental as an expense, like a $300,000 rental property down here and it'll just expense the whole thing doesn't really make sense because that rental property is gonna be generating revenue for many periods into the future. So from an accrual concept, it would make more sense for us to take that cost and allocate it over the useful life or over the period that expenditure is going to be benefiting and that's gonna be the general concept. So we'll do it with the actual property itself and then any large kind of improvements that we'd have to be putting on the books, we'd have to put those on the books as improvements as opposed to, say, simply repairs. And that's always gonna be kind of a confusing component to think about is something a repair or is it an improvement? And remember, our mindset is always trying to say, I would like to record it as an expense as opposed to capitalizing it. That's the typical mindset of the taxpayer, meaning my mindset as a taxpayer is I'd like to get the expense earlier rather than later. So if I can expense it today instead of capitalizing it, then that's what I would typically like to do. And if I have to capitalize it, then I would like a shorter lifespan and accelerated depreciation method as opposed to a longer lifespan that I have to depreciate it over and a non-accelerated, like a straight line depreciation method. So that's kind of our mindset from a taxpayer perspective to maximize our tax situation. Now, note when you're talking about other types of things that you might have to put on there, like refrigerators or appliances and this kind of stuff, you could also have accelerated depreciation that could be on the books, like a 179 depreciation and special depreciation, which could allow you to depreciate more upfront, basically, expensing it in essence, even though you have to go through a depreciation process, and that's gonna be dependent on the tax code. There's very extreme policies to allow accelerated depreciation and attempt to stimulate the economy, which obviously they stimulated the economy far past, it's overheating right now in economic terms. So you would think that they might roll back those policies, even though it's not popular to do that. But so we'll see what happens with those accelerated methods, but you gotta take into consider 179 deduction and special depreciation as well. So let's put the building on the books for first of all, now the actual property itself, if we bought it for rental property, it would be pretty straightforward, we would just put it on the books as the rental property, although it's still kind of complex because we have to add up all the stuff that's involved. But if it was personal property before that, like your personal residence and converted to rental property, it gets a little bit more confusing because now you gotta think about the cost that you had versus the fair market value of it. So just keep that into consideration. And we need to be breaking out between the amount we paid for land and the amount that we paid for the building because the land is not depreciable and the building is depreciable. So again, from our standpoint, we would typically like to put this more into the building than into the land because we would like to depreciate more of it and you can't depreciate the land. So you'd like to put more into the building so that's another thing to just kind of keep in mind. So if you were to look at your closing document, for example, for the purchase of our property here, then this is very expensive property but we're gonna say it costs $300,000. It's actually selling for multiple million dollars right now, but we're gonna say it's a $300,000 property and we would look through all the things that we had to expenditure on your closing document, including the cost of the property but all the other kind of stuff that you had to make expenditures on which were necessary in order to get the property complete and purchased and ready to be put in place for the rental. So you gotta take into consideration all those other costs as basically the part of the cost of the property and those are costs that you would like to be able to simply expense and not include them possibly at the cost of the property to get the expense now but no, typically those should be included and packaged in to the cost of the property. Now the next question is well, how do I get the breakout between the land and the building? So if I bought the property for $300,000, how do I know how much is land and how much is building because that wasn't broken out in the sales agreement. They didn't tell me how much to allocate to land versus the building. I didn't buy them separately. So you might look at the property taxes for example and the property taxes calculation will typically allocate between land and building although the last statement might not, it won't match your purchase price. So the land and the building of the last statement might have been like 150,000 or let's say, let's say 150,000 versus 20,000 which sums up to the 170,000 and then you could take the percent of that. So we're gonna say this was building and this was land. So if I take the percentage of that and I could say okay, 150 divided by the 170 and then 20 divided by the 170 and I make those into percentages is about 88 and 12 and then I would underline that. And if I sub that up, we're talking about 88 and 12 that would sum up to 100. So if I took my 300,000 then so cost was 300,000 then I'd break out the land. So land would be at 88% of it, 88% of the 300, this would be the 300 times the 88 and building, building, actually let's say building first, building and then land. Land would be at the 12% of it, making that a percent. So that would be the 300 times the 12%. So that's one way that you might go about kind of thinking about the breakout between the land and building, looking at the property taxes. And then if the IRS questions you on the calculation, you can at least say, well, I'm just trying to follow the property taxes, right? So that's, you know, other than, because they might question how much you applied to the land versus the building. Okay, let's put it on the books then. Let's put it on the books. We're gonna go to the depreciation calculation page and I'm just gonna call it buildings. I'm just gonna say building and I should probably be more specific. I would be in practice and add the address and everything, but I'm gonna say building and then the category is going to be, this is gonna be for the building itself. And if we place it in service, let's just say at the beginning of the year, 01, 01, let's say it was the middle of January, 01, fifth, no, let's say at the beginning, 01, 01, 01, two-one. So January 1st, 2021. And the cost of the building we said was this 264706 and then no section 179. Then the method is going to be 27 and a half. So this is the maker's method, 27.5 years. It's a straight line residential rental property. And remember the government kind of forces us to use. We can't just make up our own, you know, useful life. We got to go accordance to what category the property falls under. And then prior depreciation, prior special amortization. And then we have the land, which is not depreciable. So I'm going to say land. And that's going to be under the category of land. Land, is that land? That's miscellaneous. Land, 010121. And the cost of it we said was the, what did we say, 35294. And the method there is land, which is non depreciable, non depreciable. So land or no depreciation. So that's just going to be stuck on the books kind of like an asset. And we're just going to record it. It's not going to go down in value. Okay, let's check it out, go into the forms. And now we've got our rental property here. And now we've got the depreciation pulling over of the 9,225. So obviously we didn't get the full amount of 300,000 deduction. We didn't get the building amount of 150,000 deduction. We had to put it on the books as an asset and then get the depreciation. Now we got the depreciation schedule, which is going to be over here. We got 2,021 and 2,022. Let's take a look at the full thing, even though it's kind of small, it's a little small. But hopefully we can zoom in there and check it out. So we got the building. So this is the depreciable item, 264706, 264706. Notice this stands for straight line mid month. That's what the double N stands for and then a 27.5 life. So if I was to try to mirror this, I'd say, okay, the building was a mid month convention. So if I tried to recalculate this just to understand it, I'd say, okay, well that would mean that for one year it would be this divided by the life of 27.5. It's a straight line method. Let's add a decimal there. Let's underline it. So then you would think per year would be equal to this divided by that. And so there we have it. But then there's a mid month convention. So there's months in a year, months, let's get it per month, months in a year. The months in a year are 12, I believe, if I'm not mistaken. So D pre per month would then be equal to this divided by 12 is that. And then, so I'm gonna underline that. I'm looking for the underline. So then we had a half month convention. So we put it in there in January, but we only get half the month in January. So months in first year, the months in the first year were gonna be 11.5 because we have that half month convention. We make believe we bought it in the middle of the month. That's what the half month convention means. In essence, why did I center it? Shouldn't be centered. And so I want a decimal, that's what I want. So then we'll multiply that out eight times that. And this is first year D pre D pre. So nine, so did I get that right? Nine, nine, two, two, five. So that's an idea. It's a straight line mid month convention 27.5. Now, if you looked at year two, 2022, for the regular depreciation, now you get the full year straight line that would be at the 9,625. That's how much we're gonna get next time, 9,625. So that's gonna be the calculation for the, so once you get it on the books, it's pretty straightforward calculation. Notice the land is just sitting there. That's not doing anything. We're not depreciating the land. It's just on there to kind of complete the purchase process on our balance sheet accounts that should tie into our purchasing calculation. And obviously when we put this purchasing calculation in, we would add up the whole calculation. Here's the cost of it. Here's all the other stuff that we put into place to put the original amount on there. And then there's our justification for the allocation between the building and the land, for example. Now note that as we start expensing this thing, you can see with the depreciation schedule, then we can look at like the cost or basis after the depreciation is taking place, right? So the basis is gonna be going down. When you can think about this as like the book value from an accounting kind of terminology. So after that first year of depreciation, for example, we've got the total cost, let's say building and land, total cost was 300,000. And then we deprec... So the ACC deprecumulated depreciation after year one would be this. And then we're gonna say that the adjusted basis, in essence, the adjusted cost would be the 290. That's important because we would rather have a higher basis too, because when we sell the property, it's gonna be the sales price minus the basis. So as we're eating up the accumulated depreciation, we're digging into the basis, which means that when we sell it, we're more likely to have a gain at the point in time that we sell it. Now of course, when you're talking about a gain with a real estate, you gotta think, okay, at that point in time, could I convert it to personal property and possibly get an exemption on the gain? Is the gain gonna be a capital gain versus the depreciation which might be a benefit on ordinary income? Might there be a difference between those things and those kind of things add into the complexity of the discussion as well. But let's talk about other depreciable kind of stuff that we might have then. We could have like five year property, we could have seven year property, 15 year property, other types of things that we need to put on the books as an asset. So five year property could include things like computers and equipment, for example. So let's say we had some five year property we put on the books here and I'm gonna put it on the books, five year property and let's say we just had computers and equipment. Let's just say computers, computers in our rental activity. So then I'm gonna say this is going to be five, this is gonna be equipment, I called it, right? I called it machinery and equipment. Let's put it on the books. Let's say it happened on 21521 that we bought that and let's say it was for 2400. I'll leave the section 179 as is and this is gonna be five years and notice I have the five years I got the maker straight line but typically you're gonna choose the five years equipment. Also note that you have special limitations for the auto, that's why they have another five years for the auto because you might have caps with the regards to the auto for luxury automobile kind of caps and stuff but we'll keep it with the equipment. Now if I don't do anything else the system is gonna try to calculate any 179 and special depreciation we might get. So if I was to go back on over here and check this out I go back to my depreciation schedule and I'm gonna say regular and so now you got your equipment down here, 2400. Notice that it took the whole thing and special depreciation. So it's trying to basically and those are accelerated depreciations that have been put in place and those are the types of kind of things that you would expect the tax code to fluctuate in as to how much you might have in terms of advanced depreciation like 179 depreciation or special depreciation which are kind of like a topic in and of themselves but in that case it kind of acts as if you got to write off the whole thing in the first year. So it kind of almost negates the idea of putting the thing on the books as a depreciable asset because it takes a little bit more time to put it on the books but you may get the full amount of the depreciation as it rolls in to the depreciation schedule on the schedule E and note that they do that, they do that special depreciation to kind of stimulate the economy. So again, right now the economy is overheated. So this is one thing that you would think from an economic standpoint they would start to taper back on but from a political standpoint that's not popular so you never know what's gonna happen would like the special depreciation and the 179. If we were to try to take that layer off let's say they didn't qualify for the special depreciation and just look at the normal depreciation under makers. So now I've removed the special depreciation and again of course if you could get the special depreciation you would typically want to be able to get the special the 179 but I've removed it because this is back to like the normal rules which you would think would be more consistent over time and so now you've got the 200 DB which is double declining balance I would call it and then the half year that stands for half year convention, five year life and then the 200 that's the rate that we're gonna use on like a table kind of method. So if I was to reconstruct that it's a little bit more confusing if I was to say okay we put this on the books this is equipment, had a cost of the, what did I say, I said that had a cost of the 2400. So then we're gonna say that the useful life so the life was five years and so if I underline that I'm gonna say then this is gonna be equal to this divided by five which gives me a rate if I was to look at the rate would be this divided by this making that a percent that would be our 20% you can also think of it just as one divided by five would be the 20% that's our straight line rate if it was a double declining balance now if I was to double it for double declining then the double declining rate would be the 40% so this is where it gets a little bit tricky because you could see they multiplied it by the straight line rate which is the 20% that's because of the half year convention so in other words I would normally take your one depreciation, your one D-pre D-pre would be equal to the 2400 times the 40% but it's not that because there's a half year convention half year convention which means we assume we bought it in the middle of the year so we divide it by two so I'm gonna take that divided by two and that's year one, that's your one depreciation so basically you could just do the straight line because of the half year convention which again is kind of confusing if I was to take that to year two using a normal double declining balance I now have the original amount of the 2400 minus the amount that we depreciated last year that's gonna give us then the 1,920 and then I would multiply that not times the 20% but times the 40% because that's the double declining rate and so in year two you would think it would be 768 if there was a normal double declining with the mid-year if I go to year two here, 2022 you could see that we have the 768 in year two so just to get an idea obviously you can see that we're depreciated more in the current year then in the following year that's normal kind of double declining well we would be depreciating more except we had the half year convention so we bought it in February we assumed we bought it in the middle of the year 615 and that's why it basically breaks down to that straight line which confuses people because it's not really straight line even though it looks that way in the first year of the purchase okay so you could have seven year property for example so we might have seven year property which includes stuff like office furniture and you wanna be specific when you put this on the books notice I just said computers here you wanna actually list out the actual computer so Dell computer here's the number on it because if you bought like five of them you probably wanna put each of the computers on the books separately because if you sell one of the computers or one of them breaks you gotta take that thing off the books and when you take it off the books if you can't find it on the depreciation schedule or you grouped 10 computers into one line item then it causes problems when you sell the asset or it's disposed of in some way so now let's say but I'm doing generic stuff here so I'm gonna say furniture so again you wanna list out this is the sofa the brown one with a tag on it or something like that so that you can find it in case you sold it or something like that at a future point you can find it on the depreciation schedule but we're being generic here we're being generic okay so activity and this is gonna be the category of furniture and this let's say this happened on O3 1521 and it costs 1,900 I don't know and then the rate on that one is this one's gonna be seven year property we're gonna say it's seven year and again we would probably choose the double declining not the straight line because we would get more upfront if I don't do anything to it it'll probably try to take the special depreciation again so you get the special depreciation if I was to eliminate that just so you can see the calculation of the double declining I could say we don't qualify for special we'll not take the 179 and we'll just take a look at it here and then you could see the double declining calculation here for year 2021 and then the second year calculated here so I won't do the calculation again because it's similar and then we could have 15 year property for like roads and fences I won't put that in at this point now you also might have improvements that you put on the property right if you had improvements on the property like you expanded on the property your first thought is like well can I put it into repairs maybe because then you get to expense it if it's bringing it back to like it's normal operating condition maybe in repairs but if not then you might have to put it into improvements and when you're doing the bookkeeping for this type of stuff you're kind of looking at that kind of thing if you see a lot of stuff in supplies you're like oh there's 100,000 in supplies that seems like maybe we should be capitalizing something there or repairs has a large dollar amount in it that might make you dig into it and see if there's anything that should be capitalized because if you don't do that then that could be kind of like a red flag you would think for the IRS as well if there's this large amount that's going to be expensed if you do expense a large amount because you believe it should be categorized as repairs instead of as improvements for example you want to make sure you log that down as to your rationale in the event that there's an issue with it so if we had like other improvements that we had to put on the books then we might put that on as another line item improvements and again you'd want to list out the thing that was the improvement that was put into place and I'm being generic category is going to be the improvements and let's say this happened on let's say oh seven oh two 21 and let's say it was for 60,000 improvement of some kind and then or let's make the improvement in 2022 just so we could see it so that happened in the following year we put it in place and then we added an improvement in the next year and the method it's gonna generally have to be aligning with the method of the property itself which was that 27.5 year straight line residential real estate and so that's a long time to have to write off that improvement over so what you'd like to be able to do is categorize the improvement first as a repairs or something if you could and if you can't then maybe be able to categorize it as some other depreciable asset if possible that has a shorter life to it and then if not then you gotta categorize it over that long life which is gonna be not as beneficial typically so if I look at the depreciation schedule now we've got the building and the land and then if I go to 2022 not in the current year now we've got the category of the improvements as well now also note that if you purchase a lot of stuff like at the end of the time period it would convert from a mid a mid month convention for I'm sorry a mid year convention for things like the furniture and so on to a mid to a mid quarter convention so let's say we made a substantial purchase of like five year property for example and it was I'm gonna call it I'm gonna call it equipment and again that's very generic and not good you'd wanna be more specific so that you know what kind of equipment you're purchasing but let's say we bought equipment for on and let's say that happened on 12 12, 2021 and let's say it was a significant amount like 70,000 of equipment and so that's gonna be most of the equipment and so I'm gonna say that was five years so now if I move back on over because I believe it's more than 40% was purchased in the fourth quarter now they're gonna say we're not gonna allow you that mid month convention in the same manner possibly let's take off the special depreciation so it's a special depreciation I'm gonna take that off just to look at this mid quarter thing a little bit more closely so if I go back on over so now it's got notice it switched this to 200 double double declining balance I would call it mid quarter instead of the mid month convention that I'm sorry instead of the mid year convention and then you've got the rate that's being applied to it and notice it also did it to the computers before I put that in place the computer was at a mid year convention instead of a mid quarter convention so just to see that so that basically means in the first year instead of assuming it was purchased in the middle of the year we assume it was purchased in the middle of the quarter now note I can see you could see this change if I made that dollar amount on this one something small smaller at least like let's say it was 2000 and I go back on over now it doesn't it doesn't do that so now we're on the half year convention again so if you see that switch over and you say hey I thought there was a half year convention on like machinery and equipment and so on then but if you made a large purchase in the last quarter then it's going to it's going to kick it over and it's going to kick everything over to the mid quarter convention that the rationale being that it looks like you might be taking advantage of the of the mid month convention and some of the stuff might not be you know as relevant when there's like a 179 and special depreciation in place but again those things could could fall away at some point you might not always qualify for it so it's good to have an idea of the you know convention methods because those will probably stick around even as the accelerated depreciations with the 179 and the special fall in and out of favor as changes in the economy happen and and the you know whatever happens with the law happens with the law so we'll see and we'll follow it and it'll be interesting