How is existing depreciation (related to purchased improvements) treated during renovation for a rental property that was first rented, then renovated, then rented again?

[mirralis]

I purchased a property in 2015, rented it and deducted all expenses related to rental, including depreciation of original improvements purchased. In 2016 I renovated (so property was vacant) and in 2017 rented again. What do I do with the original depreciation during the period of renovation? Do I simply put it on hold and then re-start it after the property was again available for rent? Do I capitalize it as part of the "carrying costs" during the renovation? Again, this is not a question for what to do with the renovation costs, but rather how the original depreciation is treated during the period of renovation. For example. I know that any hard carrying cost during the renovation have to be capitalized (interest, utilities, property taxes).  

[Carl]

This is important. Did you report on "ANY" prior year tax return that you converted the property to personal use? Also, did you "NOT" file a SCH E with your 2016 tax return? (I am assuming you have already filed the 2016 return. Let me know if you have not.)

[mirralis]

Never been converted to personal use. Only stopped renting to renovate. Schedule E filed for the period of 2016 while it was rented (renovation took place from August 2016-August 2017). I did file the 2016 return. What do I do with the Depreciation that would have been attributable to Aug 16 - Aug 17?

[Carl]

If you never converted it to personal use, then depreciation never stopped, and it should not have. Since you never converted it to personal use on your 2016 return, depreciation was taken for the entire tax year. I was of the impression the property was not rented for one single day in 2016. Since it was, then you're fine. The only way to stop depreciation, is to convert the property an all it's assets to personal use. But when you do that, for the period of time it was personal use, you can only claim/deduct mortgage interest and property taxes. The property doesn't depreciate while classified as personal use, and you can't deduct *any* expenses incurred while personal use - including the property insurance.
So if you never converted it to personal use, in my opinion I would not bother doing so in your situation.  Now I do question some comments you have in your original post. The way you worded your comments calls some things into question.
" purchased a property in 2015, rented it and deducted all expenses related to rental, including depreciation of original improvements purchased"

Ummmm.... including improvements? I hope so. However, property improvements done "before" you purchased the property are not listed separately in the assets section. Upon your initial purchase, the absolute only thing that should be listed in the assets section, is the property itself and that's it. Absolutely nothing else. THat property itself is deprecated over 27.5 years based on what *you* paid for it in total.
Property improvements are added if *you* pay for them after your purchase of the property. While your improvements are depreciated over 27.5 years the same as the rental property, the depreciation doesn't start on your improvements until you actually place them "in service". The in service date for your improvements will be in 2017. So you won't even list them at all on the 2016 return since they were never "in service" to a renter in that year.
So as to avoid having to go back and amend the 2016 return, if I were you, I"d leave it as is.
Your rental income will be whatever you collected for the 2-3 months it was actually rented out. Leave it as a rental and all utility costs (electric, gas, etc) and maintenance cost incurred while you were renovating can be deducted as a rental expense. Since the period of renovation crosses tax years, make sure you only claim those expenses incurred *and paid* in the 2016 tax year.
Otherwise, if you amend the 2016 return to convert the property to personal use which would have occurred one day *after* the last renter moved out, you can not claim any utility cost you incurred/paid after the conversion date. Also, while classified as personal use routine maintenance costs are flat out not deductible, and neither are repairs. For example, if you paid for lawn care during the period of personal use, you can't claim or deduct it at all, under any circumstance. If you replaced a broken door knob, that's a repair and is not deductible if done and paid for while the property is classified personal use.
What follows are standard difinitions of just what is a property improvement, repair, and maintenance. I basically took the IRS gobbledygook and translated it to plain English so we common folk can understand it.

• 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 as your primary residence or 2nd home or vacation home 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 POPERTY 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 classified as cleaning/maintenance costs. They are instead classified as startup costs, amortized as such and depreciated over time.

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 classified as startup costs, amortized as such and depreciated over time.

Startup Costs

Please note that if residential rental income is not your PRIMARY business, and your PRIMARY source of income, then your rental business is considered to be passive, and you flat out, no way, no how , are not allowed to deduct your startup costs. Period. The IRS says so. See https://www.irs.gov/pub/irs-drop/rr-99-23.pdf and please take note that rental property produces “passive” income, while other types of businesses produce “active” income. Your rental property is not classified as your “active” business, unless you are a real estate professional, an active participant in the management of the property, and it provides a substantial (more than half) amount of your taxable income for the year. All three requirements must be met. There are no exceptions

Start up costs are expenses incurred while preparing the property for rent, with the express purpose being to prepare it for rent, before it is available for rent. These costs do include repair, cleaning and non-recurring maintenance cost. It does NOT include property improvements. With a normal business that produces active income (rental income is passive) you would amortize these costs over 15 years. But you can’t do that with a rental property. However, you can deduct a maximum of $5000 in startup costs in the first year the rental is available for rent, PROVIDED your total startup costs do not exeed $50,000. This is reported on line 18, “Other Expenses” of SCH E, and should be labeled “start up expenses”.

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 3rd 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.

[mirralis]

Carl, thanks for the extensive answers. A couple of points to make and I will reiterate my understanding of what you are recommending as it relates to the depreciation (and now other carrying costs):
- This property has always been and will continue to be a rental since the date of original purchase. No confusion here. Not sure if there is a reason you kept referring to conversion for personal use. Is there some sort of requirement I do so during the renovation?
- This was not some small renovation - major gut and remodel costing $300K+. Place was not habitable hence not available for rent during the renovation.
- For the original depreciation, I was referring to the depreciation of the original purchase price allocated towards improvements, NOT to the cost of improvements made by prior owners, so I think we are on the same page here.
- Fully aware that the remodeling costs cannot be depreciated until the remodel is complete and the property is being rented again.

Just to reiterate my understanding on two points:
1. You are saying that for tax purposes "all utility costs (electric, gas, etc) and maintenance cost incurred while you were renovating can be deducted as a rental expense". This runs counter to everything else I have read. It was my understanding that carrying costs during renovation have to be capitalized, since there is no rental income incurred that they can be offset against. What IRS ruling are you basing your assessment off of? It sounds like you are applying the same logic to depreciation of the original purchase price allocated to improvements. To clarify, this means that in 2017 I will have 4 months of rental operation, to which I will apply 12 months of interest payments, property taxes, utility bills, insurance payments and depreciation. Is that right?!?
2. For my edification, how would the analysis change if the property was not rented for even a single day during the taxable year?

[Carl]

One problem with a post such as yours (and I see it a lot) is it's sometimes difficult to tell if the poster knows what they're doing, or if they're making things vague because they're afraid of looking uneducated on the issue they are asking about. I just couldn't be sure with your original post. The tact you've been renting it for years leaned me towards "they know what they're doing" while some of your terminology (such as "carrying cost") pointed the other way. It's apparent now you know what you're doing.
For one thing, I had no clue the extent of your renovations. A $300K renovation on a rental property, even in a high cost area such as California is something that I would call more than a "total gut". I'd call it a complete razing and rebuild from the ground up. Here's how I would do this.
- Amend the 2016 return and convert the property to personal use with a conversion date of the day after the last renter moved out. Make sure to print out the two 4562's when done amending too. You'll need them both. One is titled "Depreciation and Amortization Report" and the other is titled "Alternative Minimum Tax Depreciation Report". Both reports will print in landscape format.
Upon converting, the mortgage interest paid in 2016 will be split between the SCH E for the period of time it was classified as a rental, and SCH A for the period of time it was personal use. Same split for property taxes.  Then if the program doesn't do it for you (I don't think it does) you'll have to prorate the property insurance on the SCH E for the time it was a rental. (Insurance is not deductible for the period of time it was personal use)
Then only claim those expenses on the SCH E that were incurred for the period of time it was classified as a rental. (Bear with me, and you'll see)
One thing this does is stop depreciation on the date you convert to personal use. This *is* what you want. I think what you are calling "carrying costs" is mainly depreciation. so by doing this, the depreciation stops, and you *do* want it to.

Now on the 2017 return, you "will" import the SCH E data from the 2016 .tax file. First, you're going to convert it from personal use, back to rental property with a conversion date and  in service date of the first day a renter "could" have moved in. Then work it through. After entering your rental income and expenses, that will put you in the Assets/Depreciation section. You'll see the property itself listed there already. We're going to treat this "as if" the property was completely razed down to the dirt, and rebuilt from the ground up.
So basically the way we do this, is to take all prior depreciation already taken on all assets, and add it to the cost of the land. Your cost of land did not change when you converted to personal use. But now it's going to change to a higher amount, to account for all the prior year's depreciation which is what it is I believe you are including in "carrying costs".  Since land is not a depreciable asset, this is the correct way to do this.
Delete *ALL* assets listed. (I know it's scary, but you've got the printouts of the 4562's from the 2016 return.)
Now click the "Add an Asset" button.
Select Rental Real Estate Property, and continue.
Select Residential Rental Real Estate, and continue
For "Describe this ...." I suggest you enter "New Construction".
Now lets get the correct amount to enter in the "cost" box.
Start with $300K (or whatever massive amount it was that you paid for what you are calling renovations, and I am calling a rebuild from the ground up.) Now look on the 2016 form 4562 "Depreciation and Amortization Report" and add together all the amounts in the "Cost (Net of Land)" column, the "Land" column, and add that amount to your massive renovation cost. The sum is what you will enter in the "cost" box.
Now lets get the correct amount to enter in the "Cost of Land" box.
Add together all amounts in the "Land" column, all amounts in the "Prior Depr" column and all amounts in the "Current Depr" column. Enter the total in the "Cost of Land" box. You have at this point, "carried over" all of your prior year's deprecation by adding it to the value of the land.
Your purchase date will be the date you originally purchased the property. Apparently sometime in 2015.
Click Continue.
Purchased "new", then "no, I have not always used this item 100% for business", followed by "I used this item for personal purposes before I used it for business".
Date you started using it in the business will be the first day a renter "could" have moved in,
Percentage of business use is 100%. I know that doesn't seem right, but it is. Since the date you started using it for business, you've used it 100% for business, and absolutely nothing else. What you used it for prior to converting it to a rental, doesn't count for anything.
Click continue.
Basically, that does it. Now some things you can do, *Provided* you did not live in the property for one single day during the "personal use" time for any reason (2nd home, vacation, etc.) as I assume it was basically a construction site the whole time.
For your construction costs, since the builders/renovators were using your utilities that you were paying for separate from your renovation/contruction contracts, you can add the cost you paid for those utilities to your renovation/reconstruction costs and include it in the asset 'cost" box above.

Note that what this does too is to start the property deprecation again from year zero. The prior year's deprecation is accounted for because it's "carried over" to the value of the land.
Whew! Any questions?
 **He who claims to understand the situation and all aspects of it, is obviously not paying attention.**

[mirralis]

I follow the logic here, however not keen on converting back and forth to personal use and amending returns unless I absolutely have to. I know I can add the "renovation cost" which would include the associated carrying costs (not an accountant but rather a finance guy, so excuse my terminology), meaning utilities, interest paid during the renovation, property taxes etc., as a new asset that is depreciated over 27.5 years at the time when the renovation is completed. The only challenge with doing that is depreciation as it is a non-cash expense. Why can't I just delete my previous depreciation schedule effective the date the renovation started (thereby discontinuing the depreciation expense for the renovation period), and either start re-amortizing the remaining un-depreciated balance at the time the renovation is complete over 27.5 years (I know this way I will be "losing" a marginal amount of depreciation per year as a result of re-amortizing the net amount over the full 27.5 years again) or "put the depreciation on hold" and "re-start" depreciating the acquired asset and the prior annual depreciation amount when the property is available for rent again? It sounded like your answer had more to deal with the limitations of the TurboTax system rather than the most practical way to do this? I am no tax expert, just trying to think about this logically (not always applicable when it comes to the government, I know). Thanks again for your feedback.

[Carl]

"Why can't I just delete my previous depreciation schedule effective the date the renovation started (thereby discontinuing the depreciation expense for the renovation period), "
Because all the prior year's depreciation already taken will be lost.
Some people are of the mistaken belief that depreciation is something they get to deduct forever, and once deducted, that's it. That's just not true. At some point in time, all depreciation taken on any asset will have to be recaptured and it's taxed in the year of recapture. Depreciation is recaptured and taxed when one of two things happens in your life.
 - You sell or otherwise dispose of the property
 - You die.
So until one of those things happens in your situation, you *have* to account for that already taken depreciation. You can't just delete it, with the belief it goes away forever. You can rest assured the IRS will catch it. If they catch it years down the road, the then back taxes, fines, and penalties for having just wiped it out will bite you. Generally in a situation like yours they won't catch it until the year the property is sold or otherwise disposed of. But rest assured they will catch it.
Basically with my above comment, what you're doing is in fact, starting over. But you're accounting for the prior year's depreciation already taken, by adding it to the value of the land. Since land is not depreciable, it gets transferred and added to the un-depreciable value of the land on the new asset. Every penny is accounted for.
If you want, take it to a CPA and they'll tell you just what I've told you. If they're an honest CPA not claiming to "cut corners" to save you money that is.  You gotta remember, even if a CPA does your taxes for you, it's you that signs the return stating it's true and correct under penalty of law.

[rbyu]

THIS IS EXCELLENT..

[Topangamama]

"Depreciation is recaptured and taxed when one of two things happens in your life.
 - You sell or otherwise dispose of the property
 - You die."

Don't your heirs get a stepped up basis when you die?  How is the depreciation recaptured?

[DianeW777]

There is no depreciation recapture for the heirs.  The heirs do not inherit any depreciation recapture or capital gains tax liabilities on real estate at the time of death or inheritance.

[Topangamama]

Thank you.  So Carl's statement is incorrect?

[DMarkM1]

Not necessarily.  One way to look at it is the depreciation is simply recaptured by the heirs not by the IRS upon death. 

The property receives a stepped up basis to the fair market value on the date of death.  Depreciation would then begin again on that new basis going forward. In effect it is a new property.

As Diane states the heirs would not be responsible for paying the IRS for any prior depreciation. 

[Topangamama]

"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."  

We DIYed all of the improvements to our rental property while it was still our primary residence.  

#1)   Over the years, we've bought windows, appliances, as well as tons of construction materials to be used in our reno (tile, drywall, wood, etc.).  Should these be consolidated into categories and depreciated with different schedules?  We only started renting the house in June 2019, but the improvements were years in the making.  Please advise.

[MarilynG1]

@Topangamama You are misinterpreting a bit.  You can do improvements at any time to add to the Cost Basis of your property, but they would not be depreciated as Rental Assets unless they are done after you start renting the property.

Add the value of the Improvements you did before renting the property to the Cost Basis of your Rental Property when you set up the Rental Info.

For example, if you paid 100K for the Property and added 30K of Improvements (before renting), enter your Cost Basis as 130K to start Rental Depreciation (otherwise the Cost Basis would simply be your Purchase Price).

You are getting the advantage of a much larger depreciation expense by adding the cost of your improvements to your Rental Property Basis. Keep records to verify the amount of the Improvements you added to the Original Purchase Price to arrive at your Cost Basis. 

Any improvements added after you've established an initial Cost Basis could then be added/depreciated as Rental Assets (since you can't change your original depreciable Cost Basis once you set up your rental). 

When you set up your Rental Property, you will need to split out the Cost Basis of the Home/Land separately. 

Click this link for more info on Rental Property Cost Basis.