Depreciation of new rental property

[carolynarose77]

Must I depreciate a home that just turned from a primary residence into rental property?  Can I just not take that deduction?  I don't think it would be much.

[Critter-3]

Depreciation is not an option it is required. 

[Carl]

Unfortunately, depreciation is not an option. You are required by law to depreciate rental property.  Since this appears to be your first time as a landlord and dealing with rental property, be aware the program is rather vague on some things. The below is provided to give you the clarity needed, which the program may not. If you have questions, please ask. Absolute perfection on this in the first year is not an option. It's a must. Even the tiniest of mistakes will grow exponentially over time. Then when you catch it years down the road, the cost of fixing it can be expensive. So again, if you have questions as you're working this through the Rental & Royalty Income (SCH E) section of the program, by all means, ask.

Rental Property Dates & Numbers That Matter.

Date of Conversion - If this was your primary residence or 2^nd home before, then this date is the day AFTER you moved out, or the date you decided to lease the property – whichever is later.
In Service Date - This is the date a renter "could" have moved in. Usually, this date is the day you put the FOR RENT sign in the front yard.
Number of days Rented - the day count for this starts from the first day a renter was contracted to move in, and/or "could" have moved in. That would be your "in service" date or after if you were asked for that. Vacant periods between renters do not count for actual days rented. Please see IRS Publication927 page 17 at https://www.irs.gov/pub/irs-pdf/p527.pdf#en_US_2020_publink1000219175 Read the “Example” in the third column.
Days of Personal Use - This number will be a big fat ZERO. Read the screen. It's asking for the number of days you lived in the property AFTER you converted it to a rental. I seriously doubt (though it is possible) that you lived in the house (or space, if renting a part of your home) as your primary residence, 2nd home, or any other personal use reasons after you converted it to a rental.
Business Use Percentage. 100%. I'll put that in words so there's no doubt I didn't make a typo here. One Hundred Percent. After you converted this property or space to rental use, it was one hundred percent business use. What you used it for prior to the date of conversion doesn't count.

RENTAL PROPERTY ASSETS, MAINTENANCE/CLEANING/REPAIRS DEFINED

Property Improvement.

Property improvements are expenses you incur that Improve, restore, or otherwise “better” the property. Basically, they retain or add value to the property.

Betterments:
Expenses that may result in a betterment to your property include expenses for fixing a pre-existing defect or condition, enlarging or expanding your property, or increasing the capacity, strength, or quality of your property. An example of a pre-existing condition or defect in this context would be something such as foundation repair (slab jacking) or some other, hidden and costly, anomaly.
Restoration:
Expenses that may be for restoration include expenses for replacing a substantial structural part of your property, repairing damage to your property after you properly adjusted the basis of your property as a result of a casualty loss, or rebuilding your property to a like-new condition.
Adaptation:
Expenses that may be for adaptation include expenses for altering your property to a use that isn’t consistent with the intended ordinary use of your property when you began renting the property. Adding a wheelchair ramp would be an example.

Expenses for these types of costs are entered in the Assets/Depreciation section and depreciated over time. Property improvements can be done at any time after your initial purchase of the property. It does not matter if it was your residence or a rental at the time of the improvement. It still adds value to the property.

To be classified as a property improvement, two criteria need to be met:

1) The improvement must become "a material part of" the property. For example, remodeling the bathroom, new cabinets or appliances in the kitchen. New carpet. Replacing that old Central Air unit.

2) The improvement must retain or add "real" value to the property. In other words, when the property is appraised by a qualified, certified, licensed property appraiser, he will appraise it at a higher value, than he would have without the improvements.

There are rules that allow you to just flat-out expense and deduct some property improvements instead of capitalizing and depreciating them, if the total cost of the improvement was less than $2,500. It’s referred to as “safe harbor di-minimis” But depending on the specific situation, this may or may not be beneficial. Just be aware that not every property improvement that cost less than $2,500 qualifies for this. If this interest you, the rules can get complex. So a good place to start reading is on the IRS website at https://www.irs.gov/businesses/small-businesses-self-employed/tangible-property-final-regulations. The stuff on di-minimis starts about one page down.

Cleaning & Maintenance

Those expenses incurred to maintain the rental property and its assets in the usable condition the property and/or asset was designed and intended for. Routine cleaning and maintenance expenses are only deductible if they are incurred while the property is classified as a rental. Cleaning and maintenance expenses incurred in the process of preparing the property for rent for the very first time are not deductible.

Repair

Those expenses incurred to return the property or its assets to the same usable condition they were in, prior to the event that caused the property or asset to be unusable. Repair expenses incurred are only deductible if incurred while the property is classified as a rental. Repair costs incurred in the process of preparing the property for rent for the very first time are not deductible.

Additional clarifications: Painting a room does not qualify as a property improvement. While the paint does become “a material part of” the property, from the perspective of a property appraiser, it doesn’t add “real value” to the property.

However, when you do something like convert the garage into a 3^rd bedroom for example, making a 2-bedroom house into a 3-bedroom house adds “real value”. Of course, when you convert the garage to a bedroom, you’re going to paint it. But you will include the cost of painting as a part of the property improvement – not an expense separate from it.

[carolynarose77]

Again, thank you so much for your detailed answer.  I do appreciate that!  

I have found the purchase date and price of the house but records going back to 1978 have not been digitized.  So I don't know the value of the land versus the house.  But on the 2021 tax assessment the land value is 1/3 of the  total assessed value of the property.   So would you think that I could then take 1/3 of the purchase price and say that was the value of the land?? Or should the value of the land be less back in 1978.

Thank you also for the information about the stepped up basis for Daddy's half of the house.  I will use that and add it to Mama's 1/2 of the purchase price.  I do know of some improvements they made in the last decade but I don't have receipts, records, etc. going back to 1978.  What should I do?  

Thanks again for your help.  I'm going to try and tackle it again tomorrow.

[ThomasM125]

The 1/3 allocation of the land value seems reasonable. It is advisable to assemble some documentation, maybe in the form of pictures or a least a written description of what was done in the way of improvements, as an auditor may ask about it if you get audited. They probably would not allow the deduction unless you have documentation.

[Carl]

The county courthouse where the property is located will have the records, even if not yet digitized. You'll just have to actually do there most likely, to research and find it. I would fully expect the county to have at least the purchase price from back then. If they also have the property tax records that would help to. But in figuring allocation percentage you can use the current tax records for that, and I doubt the IRS would have any issue with it.

The important thing here, is to make the attempt and be able to prove you tried should you ever be questioned on it. When all else fails, a "guess" that can be supported with things such as the cost of compatible properties in the area can be utilized. But guesses are an absolute last resort.

[carolynarose77]

I'm not going to be able to get to the county courthouse because it is 10 hours away.  But on the 2021 tax information, the land is approximately 1/3 of value of both the market value and the assessed (taxable) value.  

My question is:  In deciding on the basis for depreciation, do I use the land value on the date of purchase in 1978 ( which I will figure as 1/3 of the purchase price) or the market value of the land on the date of Daddy's death, or the assess (taxable) value of the land on the date of Daddy's death.?

I know you said that this information must be correct at the beginning because it affects every tax return going forward.  So I am trying to do what is right!!  I do appreciate your answering these questions.  You've all been  a great help to me!!

[Carl]

In deciding on the basis for depreciation, do I use the land value on the date of purchase in 1978 ( which I will figure as 1/3 of the purchase price) or the market value of the land on the date of Daddy's death

If you inherited the property, you get a step-up in cost basis. So there's no need to go back to the original purchase date. Your cost basis is the FMV of the property on the date of passing of the person you inherited it from.

Take note that the tax value as determined by the county property tax assessor is not used. This is because the assessed tax value is traditionally 30% or more below the FMV of the property.

The program only asks for tax values in some situations, only for the purpose of determining and substantiating the percentage of the cost basis to be assigned to the land.

[carolynarose77]

Thanks, Carl.  But this is not inherited property.  This is my parents' home that has been turned into a rental because my dad passed away and my mom is living with us.  So she owned the house jointly with my dad since 1978.  I found an example in Pub. 527 that showed a house bought years earlier.  The cost basis was that original cost minus that original land value plus any improvements.  So my thought is that I take the purchase price minus the land value in 1978 which I calculated at 1/3 of the original purchase price.  This is the basis Mama will use (plus improvements plus 50% of FMV on date daddy died) for depreciation purposes.

Is that correct?

I really appreciate your continuing to help me.  I want to do this rental property form correctly the first year so I don't have any issues with it later (per your good advice!)

[Carl]

This is my parents' home that has been turned into a rental because my dad passed away and my mom is living with us.

Falls perfectly in line with one of my sayings; "If it was easy, you did it wrong." 🙂

this is not inherited property.

It kinda/sorta is, as your mom inherited your dad's share when he passed.

I assume you are entering this on your mom's return, since she now owns the property. So there is a step-up in basis for your mom. How much of a step-up depends on if the property/mom's resident state is a community property state or not.

If a community property state, then you mom gets a full 100% stepped up basis of the FMV of the property on the date of your dad's passing. Otherwise, she gets to add 50% of the stepped up basis to her half of the original cost basis.

The community property states I'm aware of are : Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin. 

Now, in the tax year you convert the property from personal use to a rental, once you have determined the cost basis (at this point, I assume you have) you can use the most current tax bill for figuring what percentage of that cost basis to assign to the land. Typically, the land value will fall anywhere from 20% of the cost basis, to 30% of the cost basis. Depending on location it could realistically be an even higher percentage.

I know where I live in North East Florida, for property  west of U.S. Highway 1 the land will be approximately 20% of the cost basis. Whereas property to the east will have closer to 30% allocated to the cost basis, depending on how close to the beach it is.  Property that is "on the beach" will typically have 30-35% of that cost basis assigned to the land.

So while you can't use your most recent tax bill "as" the cost basis, you can (and should) use it to figure what percentage of your cost basis gets assigned to the land.

Also, be aware of how you enter the data on the screen that asks for COST and COST OF LAND. I only point this out because I've seen a fair number of people enter the wrong figure in the COST box after following the "example" in IRS Pub 527.

COST - The cost basis of the property including the value of the land.

COST OF LAND - The cost basis of the land.

The program (not you) will "do the math" to figure the cost basis of the structure for depreciation purposes. So you only need to figure and enter the cost basis for the land. At no time will you the user enter the cost basis of the structure only.

[carolynarose77]

Thanks, Carl.  Unfortunately I don't have 2021 tax bill.  But I have tax assessment paperwork from 2021 which shows about a 3:1 ratio so that is what I used to determine land value back in 1978.

I will go back and re-do that portion where it asks for Cost and then Cost of Land.  I took out the cost of land in the Cost line and so put 0 for cost of land (basically just figured it out for myself).  I guess I need to let TT figure it.

Again, thanks always for your help!

[Carl]

I have tax assessment paperwork from 2021 which shows about a 3:1 ratio so that is what I used to determine land value back in 1978.

That's perfectly fine and acceptable to the IRS.  When using the tax bill/assessment to figure the ratio, I think it's rather odd that the IRS wants you to use the "most current" bill/assessment on a property that may have been acquired decades ago when the ratio may have been significantly different. But it is what it is.

I will go back and re-do that portion where it asks for Cost and then Cost of Land. I took out the cost of land in the Cost line and so put 0 for cost of land

Don't do that, ($0 for cost of land) as it will create a huge issue in the future when ownership of the property changes.

I guess I need to let TT figure it.

You can do that. Basically, the program asks for your tax values for the sole and only purpose of determining the cost ratios of your "real" cost basis. The tax values are not reported to the IRS at all, and the IRS could care less about those values too.

The program takes the total tax value of the property and divides that by the tax value of the land to get a percentage. let's say that percentage comes out to 25%.  The program will then apply 25% of your "real" cost basis to the land.

[carolynarose77]

Hey Carl,

The issue I have is that Mama can only claim 1/2 of the original cost of the house in 1978.  So  on the page asking for Cost and Cost of Land shouldn't I put 1/2 of the cost of the land??  I wanted to be sure to come out with the correct basis for the house which I had figured out.  The only way to get the same number was to use 1/2 of the value of the land on the date of purchase in 1978.

BTW, I spoke with the assessor's office and tax office to try to find out the land value in 1978 but their records don't go back that far.  So per your advice I figured the percentage now and will just use it.  I agree that it was probably way less in 1978, but I would just be pulling a number from the air if I guessed. So hopefully the IRS will agree!

I've also used the Safe Harbor depreciation for a couple of items purchased new for less than $2500.  In that section I answered that the original use of the item began with me and I would take the 100% special depreciation allowance.  It did not mention Safe Harbor.  But I "assume" that is what this is?  It showed up as the full value for the item instead of any depreciated value.  These items were worth less than $500.

Thanks for guiding me through this first year!!  I really appreciate your getting back to me so quickly.  I'm trying to do Mama's return and also mine before the deadline!  Thanks for confirming (or not) the above questions!

[carolynarose77]

I think I'm second guessing myself but I'd feel better if you confirmed how I came up with the basis for depreciation.  House was owned jointly.

Mama's 1/2 of the purchase price of the house in 1978  - (minus) 1/2 of the value of the land in 1978 (which I figured at 1/3 of the total cost of the property)  + 1/2 of the improvements over the years  +  1/2 of the FMV on the date Daddy died.

Please confirm that!!!

I started to think maybe Mama's basis is just 1/2 of the FMV of the house on the date Daddy died minus 1/2 of the land value on the date he died.  But that gives a lower figure for the basis and I think you want a higher basis for depreciation purposes.

Thanks again!!

[DianeW777]

Question: Mama's 1/2 of the purchase price of the house in 1978  - (minus) 1/2 of the value of the land in 1978 (which I figured at 1/3 of the total cost of the property)  + 1/2 of the improvements over the years  +  1/2 of the FMV on the date Daddy died.

Please confirm that!!!

• Yes, this is the correct cost basis of the house without the land.

Question: In that section I answered that the original use of the item began with me and I would take the 100% special depreciation allowance.  It did not mention Safe Harbor.  But I "assume" that is what this is? 

• No.  You should say 'No' to special depreciation and then remove those assets (delete them).  Then go to 'Other Expenses' on the rental and list the items there to use the DeMinimis Safe Harbor and simply take the $500 expense without listing them as assets. If there is more than one asset you should keep the list with your tax records.

@carolynarose77