 Income tax 2021 2022 depreciation of rental property part number three. Get ready to get refunds to the max diving into income tax 2021 2022. Most of this information can be found in publication 527 residential rental property tax year 2021 IRS website irs.gov irs.gov. We're focused in on line one income of the income tax formula. We would have a sub schedule basically being an income statement with income and expenses. Expenses basically being deductions to net then is what rolls in to line one income of the income tax formula as well as eventually page one of the form 1040. This is the schedule E in essence that income statement schedule and it's the supplemental income and loss. We're focusing in on the rental real estate. So now we're looking at the cost or basis. This is a key type of calculation for the calculation of depreciation and just for the treatment of like property plant and equipment. So note that property planting equipment is not something that we're typically going to be expensing at the point in time of purchase. We have to do something that's basically an accrual kind of concept. Even if we're on a cash basis, even if we paid cash for the property planting equipment, we have to put it on the books as an asset and note that the tax return doesn't have a balance sheet. We only have the income statement, which is in essence this form schedule E. But we do have a sub schedule possibly a depreciation schedule which has a balance sheet account of these property plants and equipment assets. And then we're going to have to take the benefit of the expenses in the form of depreciation over the useful life or whatever life. The tax code allows us to allocate the expense over noting that we would like smaller lives. We would like to take the expenses earlier. We're always thinking of trying to in the taxes and where the taxpayer where usually our mindset is I'd like to take the expense earlier. I'd like to have this the life of the depreciation shorter. Therefore, and I'd like to be able to take the expense now instead of instead of basically putting on the books as a depreciable asset if I could, because that would typically be beneficial for taxes. Also note that the basis then the adjusted basis, which is you can think of kind of like as the adjusted cost is also going to be in effect when you sell the property, because it's going to be the sales price minus the basis in essence. So the basis is going to be important for a sales type of transaction as well as we've record depreciation. The basis in essence goes down or your kind of book value from from an accounting term terminology goes down. So the basis of property you buy is usually its cost. The cost is the amount you pay for it in cash in debt obligation in other property or in services. So you can think of obviously the cost of something as what you paid for it if you paid cash for it. If you took out debt for it note you're still taking out the debt, but you're paying cash in essence for the property. So now you have incurred debt and you might use the property as collateral, but you're still paid for the property. The property is still yours. Remember the bank doesn't really own the property. For example, if you have a home and you have like 80% finance to the home, you're like the bank owns 80% of it. Not true. The bank has the ability under certain circumstances to take recourse on the home if you were to default on the loan, but the bank has no ability to do anything with the property. They can't say, hey, I would like you to paint your house purple and you'd have to do it because they own 80%. No, it's a loan. It's something different. So in other property, obviously you could pay in like other property, for example, or giving goods and services. Those are all still forms of payment that should be included in the cost of the property. Your cost also includes amounts you pay for sales tax charge on the purchase freight charges to obtain the property installation and testing charges. So the things that we had to incur in order to purchase the property are also going to be included in the property. If you're talking about something like a piece of equipment like a refrigerator we talked about before or something like that, the freight to get it to us as well as the installation is also included with the price as something you got to basically capitalize. You can't expense those items. You would think you would like to, right? We would like to generally be able to say, well, maybe I have to capitalize the refrigerator, but not the freight. I'm just going to expense that and not the installation. I'm going to expense that because that would be better for me. I would like to expense what I can, but no, because those things were used in order to get the thing, the refrigerator in this case, installed and ready to go. So generally you would have to capitalize those items. 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 sales tax, you could deduct on schedule A either your income tax, which you probably would do if you were in a high cost of living state or your sales tax. And so if you deduct the sales tax, you can't basically double dip and get the double benefit from the sales tax. So loans with low or no interest. If you buy property on any payment plan that charges little or no interest, the basis of your property is your stated purchase price, less the amount considered to be unstated interest. So whenever you have a loan, if the loan is over like an extended period of time, then you have to assume there's got to be interest in it because otherwise it doesn't make sense, right? So if the loan is structured in such a way that it doesn't state what the interest is, they just say you got to pay this amount of payments or whatever, then you got to kind of assume that there's interest involved in the loan because any reasonable loan that took all information into consideration would include interest because we're aware of the time value of money, we're aware that money later on isn't worth as much, so you got to kind of figure out what the interest would be. So the unstated interest and original issue discount the OID in Publication 537. So you can look at that and do more research on that kind of thing as well in Publication 537. Real property, if you buy real property like real estate such as building and land, certain fees and other expenses you pay are part of your cost basis in the property. So when you buy the real property, obviously if you look at like the closing statement for example, you're going to have the cost of the property itself and then you can have all this other stuff that you had to do to organize the purchase of the property. A lot of that other stuff is like in similar to when we talked about the refrigerator needing freight and installation, we have similar stuff with the property, all that stuff was needed to get the property ready to go, ready to be rented or whatever, therefore it should not be expensed, which is the thing we would like to do, just to expense all that stuff earlier, right? But no, we got to put it in terms of the cost of the property because that was all included in what needed to be done to get the property ready to go. So real estate taxes, if you buy your 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. Real estate taxes can be a little tricky because later on you will be expensing the real estate taxes as they are incurred. So you might think, well, why can't I just expense the real estate taxes here instead of capitalizing them as part of the purchase price? And that's because the prior owner is the one that incurred the real estate taxes when they were the owner of the real estate. You were not the owner of the real estate when the taxes were incurred and you can imagine a scenario where the prior owner could either pay off the real estate taxes themselves that were incurred when they owned the property and increased the sales price that we would then be paying or they could say that they're not going to pay the real estate taxes and we're going to pay the real estate taxes that they incurred and possibly reduced the sales price. So you can see it's kind of packaged into the sale in that instance. Now you might look into it a little bit different if it was a purchase for a personal residence because note that we're not basically packaging it together for the rental property in that sense and you have those itemized deductions for things like taxes and the mortgage interest on the Schedule A so you can look into that in more detail. We're talking about the rental property specifically here. So you can't deduct them as taxes paid. If you reimburse the seller for real estate taxes, the seller paid for you, you can usually deduct that amount. So in that case, we're talking about our real estate taxes that the seller paid for us. So then we wouldn't include... And then if we basically deduct that amount, then we wouldn't include that amount in your basis in the property. And obviously the questions that come up here are whether or not I can deduct these amounts now as expenses or whether I have to include them in the basis of the property and I would rather deduct them now but I can't do both obviously. That would be like double dipping again. I can't take a deduction for something and include it in the basis of the property which I would eventually get a deduction for in the form of depreciation or possibly in a decrease in the gain when I sale the property calculated as the sales price minus the basis in the property. So settlement fees and other costs, the following settlement fees including closing costs for buying property are part of the basis in the property. So we've got the abstract fees. We've got the charges for installing utility services, legal fees, recording fees, surveys, transfer taxes, title insurance, any amounts the seller owes that you agree to pay. So again, anything that the seller owes, whatever categorize it is, it would be an expense to us possibly just like the taxes if we incurred it but you could see if the seller owes it, it was incurred when they had the property. So it's really just a negotiation of the sales price. We're just taking on something that they owed, we're paying part of their debt which you can imagine the same scenario, they could have paid off their debt and then increased the sales price. So it's really just a negotiation of the sales price. So such as back taxes or interest, recording or mortgage fees, charges for improvements or repairs and sales commissions. So when you go to that long list of the closing document, a lot of that stuff is going to be included as part of the cost of the property. So the following are settlement fees and closing costs you can't include in your basis in the property. So we got number one, fire insurance premiums, number two, rent or other charges relating to occupancy of the property before closing. Number three, charges connected with getting or refinancing a loan such as points, discounts point, loan origination fees, mortgage insurance premiums, loan assumption fees, cost of credit report and fees for an appraisal required by a lender. Also don't include amounts placed in escrow for the future payment of items such as taxes and insurance. So these items, if they're not included in the basis, you record them in some other way you would think, right? So you'd say the fire insurance premiums, usually if you're talking about insurance, it's a prepayment. You paid for it before you got the use of it so it might be on the books as like an asset or a prepayment or possibly an expense. Number two, rent or other charges related to occupancy of the property. So if it was rent that is being paid, then you might be, if you paid the rent, you might be recording the rent expense at that point in time. Charges connected with getting or refinancing a loan. So when we talk about the loan, now you're dealing with the loan process, not basically the purchasing, so the points and the interest and so on that would have to be recorded with relation to them. If you had to basically prepay the points we talked about, you might have to put those on the books as basically another asset that you would amortize over the life of the loan and so on. So assumption of a mortgage. So if you buy property and become liable for an existing mortgage on the property, your basis in the amount you pay for the property plus the amount remaining to be paid on the mortgage. So in other words, what normally happens is you've got a seller who owns the home and they have a loan, a mortgage on it, and then you, the buyer, take out your own mortgage or your own loan in order to pay off the seller who then pays off the loan that they have and they get to keep the difference. So you've got kind of two loans that are out there, one from the original owner and the other one that we kind of come up with when we make the purchase. But you can, of course, set up the process where you, the purchaser, are purchasing the home and you just assume the loan that the seller has. So in that case, then, what would, you'd have to say that whatever the loan was plus the, plus whatever you paid above the loan amount you would think would be the basis in the property because you assumed their loan, you paid off their debt or you assumed their debt. You would leave them of their debt. So example, you buy a building of 60,000 cash and assume a mortgage of 240,000 on it. Your basis is 300,000, right, because you paid them cash of 60,000 and you didn't take out a loan yourself to pay the price of 300,000. So you can see the normal way this would work is they would sell it for 300,000 and then we would take out a loan in order to get the 300,000 to pay off the seller who would then take that money and pay off the 240,000 that they have to pay off and they'd keep the 60,000. But instead, we just assumed their $240,000 loan and just gave them the 60,000. Therefore, we're still, the basis is still 300,000 because we relieve them of their loan obligation by assuming it. So separating costs of land and building, if you buy, 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 this is important because remember, land is not depreciable, right? Land is because it doesn't deteriorate in value, at least over human lifetimes, it doesn't go away, right? Unless, you know, if it gets sucked up under the sea or sinks or something, there was Atlantis before, but normally the land doesn't go away and the building will deteriorate. So that's why we're going to assign depreciation to the building and not to the land. But when I bought the property, say I paid this 300,000 for it, I didn't say I'm going to pay you so much for the building and so much for the land. That's a problem because when we put it on the books, we're going to have to do that. We're going to have to break out between land and building. Now you might be able to get some help from your property taxes because sometimes the property taxes try to do an assumption about the value of the land and the building. They might charge you different taxes based on that. And that can give you some indication as to what the allocation is between the land and the building. But you've got to break it out in some way. Obviously, we would like to assign more to the building. Why? Because I want depreciation. If I assign more to the land, then I never get a benefit from it until I sell it, right? If I assign it to the building, then I can depreciate it as we go. So obviously, we would lean towards the estimate and it's just an estimate, right? So we would be leaning towards wanting to get the estimate normally more on the building side of things so we can get a tax benefit from it by depreciating it and expensing it. So the part of the cost that would be allocated to each asset 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 building, who is certain of these things, right? It's completely arbitrary. You can divide the cost between them based on their assessed values for real estate tax purposes. So that's what most people do just to not get in trouble, right? You say, well, the state allocated it this way. So I'll do what the state says and use that same allocation. So example, you buy a house and land for $200,000. The purchase contract doesn't specify how much of the purchase price is for the house and how much is for the land. And it never does, obviously. We're not saying, hey, I'll pay you. We're not going to haggle over the break between the land and the purchase price. So the latest real estate tax assumption assessment on the property was based on an assessment value of $160,000 of which $136,000 was for the house and $24,000 was for the land. So we look at the property taxes. That's what they assessed the property taxes on. Notice that these amounts are the latest property taxes that may not line up to the purchase price that we paid for the home, but we can still use the same kind of ratio that they used to get an idea. So you can allocate 85%, which is the $136,000 over the $160,000 of the purchase price to the house and 15%, which is $24,000 divided by $160,000 of the purchase price to the land. So it's 85, 15 breakout between the two, adding up to 100, of course. So your basis in the house is $170,000, $85,000 of $200,000, and your basis in the land is $30,000. So we're breaking out the $200,000 by $170,000 for the building, $30,000 for the land. That seems pretty good because we'd like to put more of it on the building because I want to get a depreciation expense. Basis other than costs. So you can't use cost as a basis for property that you received in return for services you performed. So obviously you've got to take into consideration services if that was part of the purchase price that you had, not just the amount that you paid in exchange for other property. So if you paid them so much in cash and you gave them other property, then part of the cost is going to include the other property. You can't just use the cost in terms of the cash as a gift. So gifts are obviously going to be a bit confusing because it's not like a market exchange transaction. So that's going to mess up our basis calculation, which is based on two self-interested individuals making a market transaction from your spouse or from your former spouse as a result of a divorce. So clearly a divorce type of agreement is not to disinterested individuals making a market transaction. So that's going to skew our calculation or our assumptions with regards to the cost of an item with a market transaction as an inheritance. So when you're talking about an inheritance, once again, you inherited something. So that's not a market transaction. So we can't really obviously record it at cost at the point in time of inheritance. So there's going to be some special rules. We'll have to take into consideration to figure out what the basis will be in that instance. If you receive property in one of these ways, you can see publication 551 for information on how to figure your basis. So in other words, if these items happen, you don't have like a normal arms length, as they call it, arms length transaction, market transaction, which would help us with the basis. That's how we assume what the value of something is because we have two self-interested informed individuals that have contrasting needs negotiating with each other and coming up to a cost. If you have some of these other items involved, that's going to complicate that transaction and or the thing that we use to purchase the property is going to complicate the transactions such as purchasing with services or other property and so on. So if those things are involved, you can go on over to publication 551 and look into what will the basis be in those instances for more information on it. So adjusted basis to figure your property's basis for depreciation, you may have to make certain adjustments increasing and decreasing to the basis of the property for events occurring between the time that you acquire the property and the time you place it in service for business or the production of income. The result of this adjustments to the basis is the adjusted basis, increases to basis. So what kind of adjustments do we have? You've got the increases here. You must increase the basis of any property by the cost of all items properly added to the capital account. These include the following, the cost of any additions or improvements. So we purchased the property and then we improved it. So if we improve the property, then like the same kind of thing is involved here. If we improve the property, you might say, well, can I expense it when I improve it? Well, if it was a repair, maybe, but if it's an improvement, that means we got to capitalize it. And if you did the improvement before we put the property in use for its rental purposes, then it would be included in the basis of the property. So 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 amount spent after the casualty to restore the damage property. So after a casualty, you restored it, 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.