Depreciation is a systematic approach of spreading the cost of an asset's value over a given time period that is supposed to represent its useful life. The reasons for this can be due to obsolescence, inadequacy, rust, decay, or in the case of real property, wear and tear; property owners must also understand the rules for depreciation of rental property.
There are many methods that can be used for determining the depreciation of assets on a property owner's books or tax returns, and the straight line method is the most common one used for the depreciation of real estate. The straight line depreciation method for rental property described in the Modified Accelerated Cost Recovery System (MACRS) of the Internal Revenue Code is the only one that is allowed for use on tax returns.
Modified Accelerated Cost Recovery System (MACRS)
The IRS provides a system known as the Modified Accelerated Cost Recovery System (MACRS) that businesses and individuals can use to determine how they can recover the costs of depreciable assets over a course of years. It's divided into two systems, the General Depreciation System (GDP), which includes residential and nonresidential rental properties, and the Alternative Depreciation System (ADS).
General Depreciation System (GDS)
The General Depreciation System (GDS) consists of nine classes of assets. Rental properties belong to the last two property classes on the list. They are:
Residential Rental Property -This is any building or structure, such as a rental home (including a mobile home), if 80 percent or more of its gross rental income for the tax year is from dwelling units. A dwelling unit is a house or apartment used to provide living accommodations in a building or structure. It does not include a unit in a hotel, motel, or other establishment where more than half the units are used on a transient basis. If you occupy any part of the building or structure for personal use, its gross rental income includes the fair rental value of the part you occupy.
Nonresidential Real Property – This is section 1250 property, such as an office building, store, or warehouse, that is neither residential rental property nor property with a class life of less than 27.5 years.
Calculating the depreciation of rental property for each year begins with determining the date it was placed in service, it's basis, and it's recovery period. This information is used with the appropriate depreciation method to calculate the yearly depreciation expense and is commonly expressed in the form of a depreciation schedule.
The depreciation of a rental property begins on the day when it is placed in service for the production of income. This includes the day a personal residence is placed into service as a rental property.
The basis of a rental property is its total purchase price that includes certain fees and other charges incidental to the transaction. The land cannot be depreciated and must be calculated out by applying a fraction that consists of the fair market value (FMV) of the land (numerator) over the FMV of the whole property (denominator). If only part of the property is used to produce income (business use) then the depreciation must be only attributed to that portion.
Some of the expenses that are associated with the acquiring of the property are:
- Abstract fees
- Legal fees
- Recording fees
- Survey fees
- Transfer taxes
- Title insurance
Once the basis has been established, a recovery period must be determined for applying the depreciation method used under the GDS. There is a table for this provided in IRS Publication 946. It indicates the recovery period for residential rental property is 27.5 years and nonresidential rental property is 39 years.
Please continue on to Page 2 to learn more on how to calculate rental property depreciation including an example.
Averaging conventions are used under the MACRS to determine when a recovery period begins and ends. Recovery periods seldom begin on January 1, and end on December 31 in any given year. When a property is placed into service, a convention is used to determine a percentage for calculating how many months of a year that depreciation should be applied to. Real rental property uses the mid-month convention which indicates the starting date of a property placed in service for depreciation purposes should be considered as beginning in the middle of the month.
The only depreciation method that can be used for residential rental property and nonresidential rental property is the straight line method approved by the IRS. There are two ways to arrive at a yearly depreciation of rental property; one is to use the MACRS Percentage Table Guide in appendix A of Publication 946, or by calculating it by hand if computer software that does this isn't available.
Calculating the straight line rental property depreciation for the first year begins with finding the portion of the year the property was producing income and multiplying that by the depreciation for the entire year. The proper MACRS convention (mid-month for rental property) must be determined and then that number of months must be divided into 12 months. The resulting percentage is applied to the first year's depreciation.
The depreciation for the first year is arrived at by dividing the adjusted basis by the number of years in the recovery period. Depreciation for the second year and subsequent years uses an adjusted basis that is reduced by the previous year's depreciation. When the number of years is less than one, then the depreciation for that year is 100 percent of the remaining basis.
Here's an example using straight line depreciation for a building that is nonresidential rental property:
Adjusted basis: $175,000
Recovery period: 39 years
Date place in service: 3/12/xxxx
Figure the first year's depreciation by dividing 1 by 39 years. the result is .02564.
Multiply the adjusted basis by .02564 to arrive at a full year's depreciation: $175,000 × .02564 = $4,487.
Determine the number of months producing income – 8.5 (12 months-3.5 months) using the mid-month convention. The starting date is 3/15/xxxx.
Depreciation for the first year is calculated as: (8.5 ÷ 12) × $4,487 = .71 × $4,487 = $3,186.
Remaining adjusted basis is $171,814 ($175,000 – $3,186).
Years remaining: 39 years – 8.5 months = 38 years + 3.5 months = 38.292 years
Depreciation rate: 1 ÷ 38.292 years = .02612
Depreciation: $171,814 × .02612 = $4,487.78 = $4,488 (the IRS rounds to the nearest whole dollar)
Remaining adjusted basis is $167,326 ($171,814 – $4,488).
Years remaining in the recovery period: 38.292 years – 1 year = 37.292 years.
Depreciation rate: 1 ÷ 37.292 years = .02682
Depreciation: $167,326 × .02682 = $4,487.68 = $4,488
This goes on repeatedly for each year with the the increasing depreciation rate being applied to a declining adjusted basis. When the year becomes smaller than one, the depreciation for that year is the entire remaining balance of the adjusted basis.
The cost of rental property is spread out over the years due to the fact new assets don't stay new for various reasons and lose value over the course of time. This loss of value is recorded using depreciation methods. The IRS has strict guidelines regarding the use of depreciation methods that are contained in the Modified Accelerated Cost Recovery System (MACRS). The depreciation of rental property is one of the nine classes of assets in the General Depreciation System (GDS) contained in the MACRS and can be only depreciated using the Percentage Table Guide in Appendix A of IRS Publication 946, or calculated by using the straight line method described by the IRS.
Internal Revenue Service publications:
Publication 1040 Instructions, Rounding Off to Whole Dollars, Page 19 – https://www.irs.gov/pub/irs-pdf/f1040.pdf
Publication 551, Basis of Assets – https://www.irs.gov/publications/p551/index.html
Publication 527, Residential Rental Property – https://www.irs.gov/publications/p527/index.html
Publication 946, How to Depreciate Property – https://www.irs.gov/pub/irs-pdf/p946.pdf
Publication 544, Sales and Other Dispositions of Assets – https://www.irs.gov/publications/p544/index.html