Publication 527 - Residential Rental Property (Including Rental of Vacation Homes)

Publication 527

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You recover the cost of income producing property through yearly tax deductions. You do this by depreciating the property; that is, by deducting some of the cost each year on your tax return.

Three basic factors determine how much depreciation you can deduct: (1) your basis in the property, (2) the recovery period for the property, and (3) the depreciation method used. You cannot simply deduct your mortgage or principal payments, or the cost of furniture, fixtures and equipment, as an expense.

You can deduct depreciation only on the part of your property used for rental purposes. Depreciation reduces your basis for figuring gain or loss on a later sale or exchange.

You may have to use Form 4562 to figure and report your depreciation. See Which Forms To Use in chapter 3. Also see Publication 946.

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The section 179 deduction is a means of recovering part or all of the cost of certain qualifying property in the year you place the property in service. This deduction is not allowed for property used in connection with residential rental property. See chapter 2 of Publication 946.

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Using a method of accelerated depreciation may affect your being subject to the alternative minimum tax. Accelerated depreciation allows you to deduct more depreciation earlier in the recovery period than you could deduct using a straight line method (same deduction each year).

The prescribed depreciation methods for rental real estate are not accelerated, so the depreciation deduction is not adjusted for the AMT. However, accelerated methods are generally used for other property connected with rental activities (for example, appliances and wall-to-wall carpeting).

To find out if you are subject to the AMT, see the Instructions for Form 6251, Alternative Minimum Tax—Individuals.

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The following section discusses the information you will need to have about the rental property and the decisions to be made before figuring your depreciation deduction.

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What Rental Property Can Be Depreciated?

You can depreciate your property if it meets all the following requirements.

You own the property.
You use the property in your business or income-producing activity (such as rental property).
The property has a determinable useful life.
The property is expected to last more than one year.

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To claim depreciation, you usually must be the owner of the property. You are considered as owning property even if it is subject to a debt.

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Generally, if you pay rent for property, you cannot depreciate that property. Usually, only the owner can depreciate it. However, if you make permanent improvements to leased property, you may be able to depreciate the improvements. See Additions or improvements to property, later in this chapter, under Recovery Periods Under GDS.

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If you are a tenant-stockholder in a cooperative housing corporation and rent your cooperative apartment to others, you can deduct depreciation on your stock in the corporation. See chapter 4, Special Situations.

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To be depreciable, your property must have a determinable useful life. This means that it must be something that wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes.

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What Rental Property Cannot Be Depreciated?

Certain property cannot be depreciated. This includes land and certain excepted property.

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You cannot depreciate the cost of land because land generally does not wear out, become obsolete, or get used up. But if it does, the loss is accounted for upon disposition. The costs of clearing, grading, planting, and landscaping are usually all part of the cost of land and cannot be depreciated.

Although you cannot depreciate land, you can depreciate certain land preparation costs, such as landscaping costs, incurred in preparing land for business use. These costs must be so closely associated with other depreciable property that you can determine a life for them along with the life of the associated property.

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Example.(p6)

You built a new house to use as a rental and paid for grading, clearing, seeding, and planting bushes and trees. Some of the bushes and trees were planted right next to the house, while others were planted around the outer border of the lot. If you replace the house, you would have to destroy the bushes and trees right next to it. These bushes and trees are closely associated with the house, so they have a determinable useful life. Therefore, you can depreciate them. Add your other land preparation costs to the basis of your land because they have no determinable life and you cannot depreciate them.

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Even if the property meets all the requirements listed on this page under What Rental Property Can Be Depreciated, you cannot depreciate the following property.

Property placed in service and disposed of (or taken out of business use) in the same year.
Equipment used to build capital improvements. You must add otherwise allowable depreciation on the equipment during the period of construction to the basis of your improvements.

For more information, see Publication 946, chapter 1.

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Depreciation

You begin to depreciate your rental property when you place it in service for the production of income. You stop depreciating it either when you have fully recovered your cost or other basis, or when you retire it from service, whichever happens first.

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Placed in Service

You place property in service in a rental activity when it is ready and available for a specific use in that activity. Even if you are not using the property, it is in service when it is ready and available for its specific use.

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Example 1.(p6)

On November 22 of last year, you purchased a dishwasher for your rental property. The appliance was delivered on December 7, but was not installed and ready for use until January 3 of this year. Because the dishwasher was not ready for use last year, it is not considered placed in service until this year.

If the appliance had 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 was not actually used until this year.

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Example 2.(p6)

On April 6, you purchased a house to use as residential rental property. You made extensive repairs to the house and had it ready for rent on July 5. You began to advertise the house for rent in July and actually rented it beginning September 1. The house is considered placed in service in July when it was ready and available for rent. You can begin to depreciate the house in July.

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Example 3.(p6)

You moved from your home in July. During August and September you made several repairs to the house. On October 1, you listed the property for rent with a real estate company, which rented it on December 1. The property is considered placed in service on October 1, the date when it was available for rent.

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If you place property in service in a personal activity, you cannot claim depreciation. However, if you change the property's use to business or the production of income, you can begin to depreciate it at the time of the change. You place the property in service for business or income-producing use on the date of the change.

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Example.(p7)

You bought a home and used it as your personal home several years before you converted it to rental property. Although its specific use was personal and no depreciation was allowable, you placed the home in service when you began using it as your home. You can begin to claim depreciation in the year you converted it to rental property because at that time its use changed to the production of income.

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Idle Property

Continue to claim a deduction for depreciation on property used in your rental activity even if it is temporarily idle (not in use). For example, if you must make repairs after a tenant moves out, you still depreciate the rental property during the time it is not available for rent.

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Cost or Other Basis Fully Recovered

You must stop depreciating property when the total of your yearly depreciation deductions equals your cost or other basis of your property. For this purpose, your yearly depreciation deductions include any depreciation that you were allowed to claim, even if you did not claim it. See Basis of Depreciable Property on this page.

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Retired From Service

You stop depreciating property when you retire it from service, even if you have not fully recovered its cost or other basis. You retire property from service when you permanently withdraw it from use in a trade or business or from use in the production of income because of any of the following events.

You sell or exchange the property.
You convert the property to personal use.
You abandon the property.
The property is destroyed.

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Generally, you must use the Modified Accelerated Cost Recovery System (MACRS) to depreciate residential rental property placed in service after 1986.

If you placed rental property in service before 1987, you are using one of the following methods.

ACRS (Accelerated Cost Recovery System) 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.

See MACRS Depreciation, later for more information.

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Continue to use the same method of figuring depreciation that you used in the past.

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Generally, you must use MACRS to depreciate real property that you acquired for personal use before 1987 and changed to business or income-producing use after 1986. This includes your residence that you changed to rental use. See Property Owned or Used in 1986 in Publication 946, chapter 1, for those situations in which MACRS is not allowed.

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Treat an improvement made after 1986 to property you placed in service before 1987 as separate depreciable property. Therefore, you can depreciate that improvement as separate property under MACRS if it is the type of property that otherwise qualifies for MACRS depreciation. For more information about improvements, see Additions or improvements to property, later in this chapter under Recovery Periods Under GDS.

This publication discusses MACRS depreciation only. If you need information about depreciating property placed in service before 1987, see Publication 534.

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Basis of Depreciable Property

The basis of property used in a rental activity is generally its adjusted basis when you place it in service in that activity. This is its cost or other basis when you acquired it, adjusted for certain items occurring before you place it in service in the rental activity.

If you depreciate your property under MACRS, 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 discussions.

If you used 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. See Basis of Property Changed to Rental Use in chapter 4.

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Cost Basis

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. Your cost also includes amounts you pay for:

Sales tax charged on the purchase (but see Exception below),
Freight charges to obtain the property, and
Installation and testing charges.

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if you deducted state and local general sales taxes as an itemized deduction on Schedule A (Form 1040), do not include those sales taxes as part of your cost basis. Such taxes were deductible before 1987 and after 2003.

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If you buy property on any time-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. See Unstated Interest and Original Issue Discount (OID) in Publication 537, Installment Sales.

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If you buy real property, such as a building and land, certain fees and other expenses you pay are part of your cost basis in the property.

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If you buy real property and agree to pay real estate taxes on it that were owed by the seller and the seller does not reimburse you, the taxes you pay are treated as part of your basis in the property. You cannot 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. Do not include that amount in your basis in the property.

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The following settlement fees and closing costs that are for buying the property are part of your basis in the property.

Abstract fees.
Charges for installing utility services.
Legal fees.
Recording fees.
Surveys.
Transfer taxes.
Title insurance.
Any amounts the seller owes that you agree to pay, such as back taxes or interest, recording or mortgage fees, charges for improvements or repairs, and sales commissions.

The following are settlement fees and closing costs you cannot include in your basis in the property.

Fire insurance premiums.
Rent or other charges relating to occupancy of the property before closing.
Charges connected with getting or refinancing a loan, such as:
1. Points (discount points, loan origination fees),
2. Mortgage insurance premiums,
3. Loan assumption fees,
4. Cost of a credit report, and
5. Fees for an appraisal required by a lender.

Also, do not include amounts placed in escrow for the future payment of items such as taxes and insurance.

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If you buy property and become liable for an existing mortgage on the property, your basis is the amount you pay for the property plus the amount remaining to be paid on the mortgage.

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Example.(p7)

You buy a building for $60,000 cash and assume a mortgage of $240,000 on it. Your basis is $300,000.

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If you buy buildings and your cost includes the cost of the land on which they stand, you must divide the cost between the land and the buildings to figure the basis for depreciation of the buildings. The part of the cost that you allocate 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.

If you are not certain of the fair market values of the land and the buildings, you can divide the cost between them based on their assessed values for real estate tax purposes.

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Example.(p8)

You buy a house and land for $200,000. The purchase contract does not specify how much of the purchase price is for the house and how much is for the land.

The latest real estate tax assessment on the property was based on an assessed value of $160,000, of which $136,000 was for the house and $24,000 was for the land.

You can allocate 85% ($136,000 ÷ $160,000) of the purchase price to the house and 15% ($24,000 ÷ $160,000) of the purchase price to the land.

Your basis in the house is $170,000 (85% of $200,000) and your basis in the land is $30,000 (15% of $200,000).

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Basis Other Than Cost

You cannot use cost as a basis for property that you received:

In return for services you performed,
In an exchange for other property,
As a gift,
From your spouse, or from your former spouse as the result of a divorce, or
As an inheritance.

If you received property in one of these ways, see Publication 551 for information on how to figure your basis.

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Adjusted Basis

To figure your property's basis for depreciation, you may have to make certain adjustments (increases and decreases) to the basis of the property for events occurring between the time you acquired the property and the time you placed it in service for business or the production of income. The result of these adjustments to the basis is the adjusted basis.

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You must increase the basis of any property by the cost of all items properly added to a capital account. These include the following.

The cost of any additions or improvements made before placing your property into service as a rental that have a useful life of more than 1 year.
Amounts spent after a casualty to restore the damaged property.
The cost of extending utility service lines to the property.
Legal fees, such as the cost of defending and perfecting title, or settling zoning issues.

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Add to the basis of your property the amount an addition or improvement actually cost you, including any amount you borrowed to make the addition or improvement. This includes all direct costs, such as material and labor, but not your own labor. It also includes all expenses related to the addition or improvement.

For example, if you had an architect draw up plans for remodeling your property, the architect's fee is a part of the cost of the remodeling. Or, if you had your lot surveyed to put up a fence, the cost of the survey is a part of the cost of the fence.

Keep separate accounts for depreciable additions or improvements made after you place the property in service in your rental activity. For information on depreciating additions or improvements, see Additions or improvements to property, later in this chapter, under Recovery Periods Under GDS.

The cost of landscaping improvements is usually treated as an addition to the basis of the land, which is not depreciable. However, see What Rental Property Cannot Be Depreciated, earlier.

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Assessments for items which tend to increase the value of property, such as streets and sidewalks, must be added to the basis of the property. For example, if your city installs curbing on the street in front of your house, and assesses you and your neighbors for its cost, you must add the assessment to the basis of your property. Also add the cost of legal fees paid to obtain a decrease in an assessment levied against property to pay for local improvements. You cannot deduct these items as taxes or depreciate them.

However, you can deduct as taxes, charges or assessments for maintenance, repairs, or interest charges related to the improvements. Do not add them to your basis in the property.

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Do not add to your basis costs you can deduct as current expenses. However, there are certain costs you can choose either to deduct or to capitalize. If you capitalize these costs, include them in your basis. If you deduct them, do not include them in your basis.

The costs you may be able to choose to deduct or capitalize include carrying charges, such as interest and taxes, that you must pay to own property.

For more information about deducting or capitalizing costs and how to make the election, see Carrying Charges in Publication 535, chapter 7.

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You must decrease the basis of your property by any items that represent a return of your cost. These include the following.

Insurance or other payment you receive as the result of a casualty or theft loss.
Casualty loss not covered by insurance for which you took a deduction.
Amount(s) you receive for granting an easement.
Residential energy credits you were allowed before 1986, or after 2005, if you added the cost of the energy items to the basis of your home.
Exclusion from income of subsidies for energy conservation measures.
Special depreciation allowance claimed on qualified property.
Depreciation you deducted, or could have deducted, on your tax returns under the method of depreciation you chose. If you did not deduct enough or deducted too much in any year, see Depreciation under Decreases to Basis in Publication 551.

If your rental property was previously used as your main home, you must also decrease the basis by the following.

Gain you postponed from the sale of your main home before May 7, 1997, if the replacement home was converted to your rental property.
District of Columbia first-time homebuyer credit allowed on the purchase of your main home after August 4, 1997 and before January 1, 2012.
Amount of qualified principal residence indebtedness discharged on or after January 1, 2007.

Previous Page | Table of Contents | Top of Page | Index | Next Page Right Arrow

Chapter 2
Depreciation of Rental Property(p6)

Section 179 deduction.(p6)

Alternative minimum tax (AMT).(p6)

The Basics(p6)

What Rental Property
Can Be Depreciated?(p6)

Property you own.(p6)

Property having a determinable useful life.(p6)