Depreciation on a Rental House

[d2schultz]

My wife inherited a home in 2012 and with the estate tax work, we hired a professional. They started depreciating the rental in 2014 the year before the estate was settled in 2015. Once the estate was settled, I went back to doing our taxes but have not followed up on depreciating the rental in 2016 through 2018. I took a while to get the house ready to rent and rented for the first time in 2019. How should I handle the depreciation that I did not include in those years? There were improvements such as a patio cover and whole roof replacement in those years.

[MarilynG1]

You don't need to claim any prior year depreciation, if the property was not actually rented. Your depreciation will start in 2019. 

Generally, an appraisal is done to determine the value of the inherited property at Date of Death.

This value would be your Cost Basis when setting up your Rental Property.  Add your Capital Improvements (patio and roof) to this amount. 

Enter the property in the Rental Section, under Property Profile and Assets/Depreciation.  Enter the date it was actually 'available for rent' and Depreciation will begin there. 

Click this link for more info on Reporting Rental Income and Expenses. 

If the property was actually rented in a prior year, you can mail in an Amended Return to claim the depreciation for that year. 

Click this link for info on How to Amend a Prior Year Return.

[Carl]

They started depreciating the rental in 2014 the year before the estate was settled in 2015.

Two things with this.

 - Your cost basis on the property is the FMV on the date of passing of the original owner. NOT the date it was actually inherited and your name was put on the title. If that title transfer did not occur in 2014, then it should "never" have been reported on your tax return. Period. All rental income/expenses go to the estate until the actual date the title transfer occurs.

- If there was an active renter in the property on the date of title transfer, then it is correct to report all income/expenses for the rental on SCH E as a part of your 1040 tax return.

- If there was "NOT" a renter in the property on the date of title transfer, and no renter was in the property between the date of title transfer and DEC 31 of whatever tax year that transfer occurred in, then the property should "NOT" have been reported on SCH E for that tax year at all. It was a 2nd home and the only deductible things are property taxes and mortgage interest. Those would be included on SCH A and entered under the Deductions & Credits tab in the "Your Home" section.

rented for the first time in 2019.

This is why I believe there was never at any time a renter in the property from the time your name was placed on the deed, until you rented it out in 2019. Am I correct on this?

Once the estate was settled, I went back to doing our taxes but have not followed up on depreciating the rental in 2016 through 2018.

Assuming the house was never rented 2016-2018, there is no depreciation to be taken. It remains your 2nd home until the day you put the "FOR RENT" sign in the front yard.

There were improvements such as a patio cover and whole roof replacement in those years.

Property improvements add to your cost basis of the property. So whatever you paid for property improvements gets added to your cost basis. Remember, your cost basis is the FMV of the property on the date the original owner passed away - not the date your name was put on the title.

The below information applies to someone who just purchased a rental property. But I"m sure you'll find it informative, educational and helpful. If you have any further questions, by all means please ask.

Rental Property Dates & Numbers That Matter.

Date of Conversion - If this was your primary residence before, then this date is the day AFTER you moved out.
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 "could" have moved in. That should be your "in service" date if you were asked for that. Vacant periods between renters count also PROVIDED you did not live in the house for one single day during said period of vacancy.
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 or 2nd home, 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 add value to the property. Expenses for this 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 must 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 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.

Cleaning & Maintenance

Those expenses incurred to maintain the rental property and it's assets in the useable 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 are not deductible.

Repair

Those expenses incurred to return the property or it's assets to the same useable 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 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.

[tlgof63]

Carl, a little different twist on this question.  I recently inherited by Transfer on Death Deed a rental home of my father's.  It has been a rental for many years, but the last renter was evicted only a few days before his death.  I know my cost basis steps up and am getting an appraisal, however, I must also do repairs (broken pipe, some ruined flooring) before I can re-rent it.  Since it was rental before, in need of repair at inheritance, and most likely will not be listed for 2-3 months from date of his death, am I able to depreciate on my taxes for the unrentable/repairing period?  Thank you.

[Critter-3]

All the repairs/improvements are added to the inherited basis and are depreciated once the rental is placed in service / available for rent.  

[Carl]

By "recently inherited" I assume you mean in 2022.

am I able to depreciate on my taxes for the unrentable/repairing period?

No. Since the property did not have a renter in it, nor was it "available for rent" on your date of acquisition, (due to repairs and other work you need to accomplish) the property is treated as a 2nd home *FOR TAX PURPOSES*, until the date you place the property in service and it is available for rent and move in ready. For that period of time, the only deductions you get are any property taxes you paid, and any mortgage interest you paid. Those will both be SCH A itemized deductions, just like they are for your primary residence. But "you" had to have actually paid those expenses in 2022, in order to claim them on your 2022 taxes.

When you do convert the property to rental and it's move-in ready, then you will be able to deduct any acquisition costs you actually paid. Doesn't matter if the conversion occurs in 2022 or 2023. if you paid any acquisition costs to transfer the property into your name, they are claimed on the SCH E for the tax year you convert the property. So if you paid any acquisition costs in 2022 but don't convert the property until 2023, you can still claim those acquisition costs paid in 2022, on your 2023 tax return.

It's also important to know the difference between repair costs and property improvements, since repair costs incurred prior to placing it in service for the very first time are not deductible. But property improvements are added to your costs basis, and it does not matter when that property improvement was done either. See my other post in this tread for the definitions of repair, maintenance, and property improvement costs.

For example, the single broken pipe you reference would most likely be a repair expense. But the flooring would definitely be a property improvement. If you had to replace the flooring because of the broken pipe, then you don't need to separate those expenses out, and the total of both can be classified as a property improvement.

If you don't mind paying $400-$500 for an appraisal once all the work is done, that's the absolute best thing you can do to have an established and documented cost basis that you can prove (with the appraisal) should you ever be questioned or audited on it. it's already a given that whatever the appraised value comes out to, will be significantly higher than the cost basis of the person you inherited it from. It's also possible (and likely) that it will be appraised higher than you might expect. If you do get an appraisal (which I would recommend) ask the appraiser to separate out the values of the structure and the land. Makes it easier for figuring depreciation, since the land is not a depreciable asset, as well as giving you documentation that helps justify how you split the total value of the property between the land and the structure.

Keep in mind that the reason it does not remain classified as a rental, is because with a new owner (you), it will not be ready for "you" to rent it out "the very first time" until you have all the needed work done. How you acquired the property doesn't matter. You are the new owner, it did not have a renter in it on the date you acquired it, and it was not available for rent/move-in ready. Therefore, it's treated as a 2nd home until such time it is available for rent/move-in ready.

Now, if you acquired the property in 2022 "and" it's move-in ready before the end of 2022, the program can handle some (not all) of the splits between SCH A and SCH E for you. It just depends on the situation, what selections you make in the program, and how you answer any questions the program will ask you. If given the choice of having the program do the splits for you automatically or not, I always recommend you do those splits manually, as the program is not capable of splitting everything correctly, and the wording on some of the screens can easily be mis-interpreted resulting in you giving the wrong response.

This is important, because absolute perfection in your first year as a landlord is not an option.... it's an absolute must. Even the tiniest of mistakes can (and will) grow exponentially over time. Then years down the road when you catch the error (usually the year you sell it) the cost of fixing your boo-boo will *not* be cheap.