 Income tax 2022-2023, depreciation of rental property, makers and special depreciation 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 Tax Year 2022. You can find on the IRS website, irs.gov, irs.gov. 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. 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, it being in essence an income statement in and of itself with rental income minus rental expenses. The net rental income in essence flowing into line one income of our income tax formula. Continuing on with our discussion of depreciation, a very important topic with regards to rental property because the cost of the property itself is a huge cost. One that we would like to just expense and deduct when we pay for the rental property. But even if we're using a cash based system, the tax code won't allow us to do that forcing us to do an accrual type thing. Putting the property on the books as an asset and then taking the benefit of depreciation expense, the deduction of depreciation allocated over the useful life. So that's the general idea. Now we're going to be thinking about special depreciation allowance as we do. I think the thought process you want to have in your mind is first, what is depreciation conceptually with regards to normal accounting because that's the baseline. And then what kind of modifications are happening when we get to the tax code? So for normal accounting, the concept would be if you have a large piece of equipment or a building or something like that, it would distort the financial statements. If we were to expense them at the point in time they were purchased because there's such a big timing difference as to when we actually used the property in order to generate the revenue versus when we paid for them. So the concept would be you're going to put them on the books as an asset kind of like an investment. And then we're going to consume that asset with the use of equipment is an easier example because it actually goes down in value over its useful life allocating the cost of it to the time frame. We actually consumed it in order to generate revenue, which makes the comparison of the income statement a lot more efficient for decision making. That's the general concept. When we go to the tax code, we start with that baseline concept. But then we have different kind of incentives involved. Our goal isn't fair reporting of the financial statements. Our goal is to try to pay as little tax as possible. And therefore we're going to as the taxpayer try to take the depreciation, which is most advantageous to take the benefit as soon as possible usually and the tax code needs to be more rigid in order to stop that. And then the tax code will be adjusted for things that have other political reasons or something like that. They want to stimulate the economy or something like that. So then they add things like the special depreciation, which sometimes allow props some items to be more depreciated upfront, which would be similar to allowing us to just expense them if you were going to do that in the first place, right? And so that's kind of a weird thing. It doesn't make sense conceptually from an accountant standpoint, but it makes sense more kind of from a political standpoint and in what they're trying to do that way. All right, special depreciation allowance. For 2022, some properties used in connection with residential real property activities may qualify for a special depreciation allowance. This allowance is figured before you figure your regular depreciation deduction. See chapter three of publication 946 for details. I'll say I think I swallowed a fly there or something. I'm sorry, but also see the instructions for form 4562 line 14. If you qualify for but choose not to take a special depreciation allowance, you must attach a statement to your return. The details of this election are in chapter three of publication 946 and the instructions for form 4562 line 14. All right, makers depreciation. This is the big one that so when we think about depreciation methods, oftentimes for the tax code, we're thinking about some variant of the makers depreciation, which is basically just taking normal depreciation concepts and then putting them into this more stringent code of the tax of the tax code. Straight line or double declining, those kinds of conceptual frameworks. And then we're going to try to put them in the stringent tax code system. All right, so most business and investment property placed in service after 1986 is depreciated using makers MACRS. So this section explains how to determine which makers depreciation system applies to your property. It also discusses other information you need to know before you configure depreciation under makers. This information includes the property's recovery recovery class applicable recovery period convention placed in service date basis for depreciation and depreciation method. Okay, so let's do a quick recap and we'll probably look at them in more detail. So when we think about the depreciation, we got to know the recovery class. So we have to classify the type of asset and the tax code is going to be more stringent than like generally accepted accounting principles generally because that class is going to restrict the depreciation methods that you can get it. So you have to get the right bucket of the thing that you have so that you can be in alignment with the more stringent rules on the tax code with the generally accepted accounting principles. If you were doing depreciation for general generally accepted accounting principles, you would be trying to have your depreciation method that reflects your financial statements as accurately as possible. So there are kind of two different things there but a similar depreciation concept applicable recovery period. Now the recovery period is basically how long like the useful life you're going to be depreciating or allocating the cost or basis of this thing over. And typically it will be dictated by the recovery class, the bucket that it's been put in and then the tax code will give you an option or very limited options of what your applicable recovery period will be. And then the convention has to do with when you purchase something we can simplify the calculation instead of saying I purchased it on February 7th and then try to calculate the depreciation for the part of that month. It would be easier if we can just assume that everything was purchased in one day. So for some property it might have a mid year convention and we just assume everything was purchased in the middle of the year making the math easier. Or we might have a mid month convention or we might have a mid quarter convention. So that's a simplification tool placed in service date. Obviously we need to know when it was placed in service and that becomes a little bit of an issue sometimes with certain pieces of property that you purchase but aren't in use yet. The basis for depreciation so what's going to be kind of like the adjusted cost usually is the basis, the amount of the expense. If you paid for something it would be what you paid for it typically and what you paid to get it ready for use. What's the basis that's going to be allocated over the useful life and then the depreciation method which again will be dictated basically by the recovery class. The bucket that you put into it and the tax code might give you some limited options on the method which include things like pretty much like a double declining method and accelerated method or straight line method which is kind of like the standard. Alright depreciate when I say it's the standard straight line is like the standard for you to think about it. Like you want to first think straight line and then alter it to some of these other kind of concepts like an accelerated method like double declining. Okay depreciation system. Makers consist of two systems that determine how you depreciate your property. You've got the general depreciation system the GDS and the alternative depreciation system the ADS. You must use GDS unless you are specifically required by law to use ADS or you elect to use ADS. So then again normally we're thinking when you think of makers most people probably just think you know basically the general depreciation system because that's you know the default. It's usually an advantageous system because it has the double declining for some pieces of property often times but you have certain circumstances when you might be in the alternative depreciation system. And there might be some instances where it would be advantageous to elect to be in the alternative depreciation system. So you have a little bit of flexibility once you put your asset in that bucket of assets. Excluded property. So you can't use makers for certain personal properties such as furniture or appliances placed in service in your rental property in 2022. If it had been previously placed in service before 1987 when makers became effective. So in most cases personal property is excluded from makers if you or a person related to you owned or used it in 1986. Or if your tenant is a person or someone related to the person who owned or used it in 1986. So that's like the cut off when this change happened. However the property isn't excluding if you're 2022 deduction under makers using a half year convention. So there's the convention meaning we kind of assume it was purchased in the middle of the year is less than the deduction you would have under ACRS acres. So for more information see what method can you use to depreciate your property in chapter one of publication 946. All right. Electing ADS. If you choose you can use the ADS method for most property under ADS. You use the straight line method of depreciation. So a lot of the times the makers depreciation when we're talking about like equipment and stuff like that defaults to the double declining balance. Which is usually good because from our perspective as the taxpayer we want to usually get more of the deduction up front. Although there are times when you could say I would rather get the depreciation later. For example if my taxes if my income is quite low in the current year and I expect it to be much higher in latter years. Then my tax rates going to be way a lot lower because of the progressive tax system. So I might say I would like to defer my depreciation to a point when I'm in a higher tax bracket. And therefore the depreciation will be more advantage. But normally we would like to get the depreciation earlier because time value of money. Time is money. We'd rather get it sooner rather than later they can always change the laws and mess us up on our whole plan anytime. So we'd rather get it done now if we can usually. So the election of ADS for one item in a class of property generally applies to all property in that class placed in service during the tax year of the election. However the election applies on a property by property basis for residential rental property and non residential rental property. If you choose to use ADS for your residential rental property the election must be made in the first year the property is placed in service. Once you make this election you can never revoke it. So make sure it sounds quite intimidating there. But yeah you want to make sure it's consistent because the depreciation you can't like switch depreciation schedules. You can see how that would be quite messy if you've ever worked with these depreciation schedules. So for property placed in service during 2022 you make the election to use ADS by entering the depreciation on form 4562 part 3 section C line 20 C. So property classes under GDS. So each item of property that can be depreciated under makers. So now we're talking makers and the normal GDS now is assigned a property class determined by its class life. The property class generally determines the depreciation method recovery period and convention. So once again each item of property that can be depreciated under makers is assigned a property class. So now you're going to say OK where does this fit on the property class. What bucket does it fall into determined by its class determined by its class life. The property class generally determines the depreciation method the recovery period and convention. So once you've got that right the class everything else kind of kind of follows right. So you have very limited options because the tax code is quite stringent after that point. All right. So the property classes under GDS or you got the three year property. You got the five year property. You got the seven year property the 10 year property the 15 year property the 20 year property. And then we got the non residential real property and the residential rental property. I'm sorry non residential real property and residential rental property. So those are the buckets that we kind of fit the stuff into. And then once they're in that bucket then we have more limitations or that will drive in essence some of the other things. Some of the other things we need to calculate the depreciation or populate this into the tax software to have the tax software help populate the depreciation and calculate it. Under makers property that you placed in service during two thousand twenty two in your rental activities generally falls into one of the following classes. So you got the five year property. This class includes computers and peripheral equipment office machinery typewriters calculators copiers et cetera automobiles and light trucks. So this class also includes appliances carpeting and furniture used in a residential rental real estate activity. Our depreciation is limited on automobiles and other property used for transportation and property of a type generally used for entertainment recreation or amusement. So remember as we look at these classes we typically would like to try to have the smaller life for our perspective from the taxpayer perspective is I would like to get the expense today. Usually if I could well I can't they're going to make me depreciated. OK well then can I get a special depreciation or one seventy nine so I could still get the expense today. Basically if not well then they're going to I still have to depreciate something over a useful life. Well then I want the useful life to be as small as possible. So five year five year as opposed to ten year if possible if I can fit something in that class versus another class as the general idea. When you get to things like automobiles the IRS is going to be skeptical and possibly putting more stringent restrictions on the depreciation of automobiles because oftentimes people buy extravagant automobiles and then write them off as if it's like they needed that to drive over to the to their clients place or something which they could have done in a golf cart or you know or something like that. So it seems a little excessive to the IRS is a bit skeptical. So seven year property. This class includes office furniture and equipment desks file cabinets and similar items. This class also includes any property that doesn't have a class life and that hasn't been designated by law as being in any other class. So it's kind of like the default class if you find stuff that doesn't neatly fit into one of these categories. Fifteen year property. So these these these two five and seven are kind of like some of the more common properties when you're not talking about like big stuff like the real estate. You know the actually property itself and stuff like that. And then you got the 15 year property. This class includes roads fences and shrubbery if depreciable residential rental property. So this class includes any real property that is a rental building or structure. So now this is the actual building now and we're talking residential rental property this time. So this class includes any real property that is is rental building or structure including a mobile home for which 80% or more of the gross rental income for the tax year is from dwelling units. It doesn't include a unit in a hotel motel in or other establishment where more than half of the units are used in a transit basis. So you have to get into that. You get into a little bit of the weeds in terms of is this more of like a motel or hotel in which case you would think it's more of like a business kind of thing that you might be subject to like self employment tax and stuff on. Or is it or is it going to be you know rental property where you're not providing substantial services and stuff like that. So so which is more passive you would think in nature. So if you live in any part of the building or structure the gross rental income includes the fair rental value of the part you live in. All right. So here's a table of these items. So you got makers recovery periods property used in rental activities. So you've got the type you've got the general depreciation and the alternative. Oftentimes we're thinking general depreciation and the table format here. So type of property computers and the peripheral equipment five year office machinery such as typewriter calculators copiers. We've got the automobiles also five years but we know if there's those others restrictions possibly with the automobiles that we talked about light trucks and then appliances such as stoves refrigerators five year carpets five and furniture used in rental property five years. So note that as you're as you're thinking about the rental property sometimes you run into these situations where it's like well do I have to include this thing. Like a carpet or something like that as part as part of the of the of the building itself or an improvement. In which case I might have to like depreciate it over like 27 years 27 and a half or 30 years or something like that. Or can I think of it as a carpet which which would be depreciated over five years. Right. So you can see how you get into these kind of situations where would it be possible for me to parse something out from a big structure that I have to depreciate over a long useful life to smaller components which could be beneficial and that I might be able to depreciate them sooner and you get on those kind of issues could come up from time to time. So office furniture and equipment such as desks files seven year any property that doesn't have a class life that hasn't been designed by law as being in any other class seven year roads 15 year shrubbery fences 15 year and then the residential rental building or structure and structural components such as furnaces water pipes venting etc. 27.5 years for the general depreciation system. All right recovery period under GDS the recovery period of property is the number of years over which you recover its cost or other bases the recovery period are generally longer under a DS then GDS. So if I look at these and I compare these some of the recovery periods are longer under the ADS versus the GDS which is another reason why us as taxpayers will typically want the GDS. And that's why it's the default because we will typically want shorter periods that allows us to take the depreciation deductions sooner than later. So the recovery period of property depends on its property class under GDS the recovery period of an asset is generally the same as its property class. So in other words you might be saying well what the recovery periods pretty much straightforward here for most of these areas because the property class says its five year property. You know if it was in that so that sounds like that's the recovery period although when we got down to the to the residential rental property it didn't actually give us the years in the name of the class right so but a lot of times it seems a little redundant. So class lives and recovery periods for the most assets are listed in appendix B of publication 946 C table to one for recovery periods of property commonly used and residential rental activities. Additions or improvements to property treat additions or improvements you make to your depreciate your depreciable rental property as separate property items for depreciation purposes. In other words you put an improvement on like a new roof it's not a repair you can't you can't take the expense when you did it but rather have to put it on the books as an asset. It's not going to be included or you're not going to like add it to the cost of the building that's already on the books you're going to make another item for the improvement. So the property class and recovery period of the addition or improvement are the ones that would apply to the original property if you had placed it in service at the same time as the addition or improvement. So the recovery period for an addition or improvement to the property begins on the latter of the date the addition or improvement is placed in service. My voice is going. Hold on. I need some coffee. All right. I'm back. I'm back got to take care of the voice. So the date of the property the date of the property to which the addition or improvement was made is placed in service. Okay. Example. Let's take a look at an example. That'll be helpful. So you own a residential rental house that you have been renting since nineteen ninety nine and depreciated under a R. A. C. R. S. acres. You built an addition onto the house and placed it in service in two thousand twenty two. You must use makers for the addition under G. D. S. The addition is depreciated as residential rental property over the twenty seven point five years. So you would think that basically the two things would kind of match. You had the house that you were depreciation depreciating and then you did the improvement to the home. You would think the two would be the same and they would except for the fact that the makers came into play at a later point in time. I'm later than later than now. So now you've got the situation. Well if you would have you know put the home in place the rental property in the current timeframe you would have used the makers but and so that's that's the method you should use for the improvements then would be the general idea of my interpretation of it which is the twenty seven point five under the makers G. D. S.