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Pub. 17, Your Federal Income Tax 2004 Tax Year

Chapter 10 - Rental Income and Expenses

This is archived information that pertains only to the 2004 Tax Year. If you
are looking for information for the current tax year, go to the Tax Prep Help Area.

Introduction

This chapter discusses rental income and expenses. It covers the following topics.

  • Rental income.

  • Rental expenses.

  • Personal use of dwelling unit (including vacation home).

  • Depreciation.

  • Limits on rental losses.

  • How to report your rental income and expenses.

If you sell or otherwise dispose of your rental property, see Publication 544, Sales and Other Dispositions of Assets.

If you have a loss from damage to, or theft of, rental property, see Publication 547, Casualties, Disasters, and Thefts.

If you rent a condominium or a cooperative apartment, some special rules apply to you even though you receive the same tax treatment as other owners of rental property. See Publication 527, Residential Rental Property, for more information.

Useful Items - You may want to see:

Publication

  • 527 Residential Rental Property

  • 534 Depreciating Property Placed in Service Before 1987

  • 535 Business Expenses

  • 925 Passive Activity and At-Risk Rules

  • 946 How To Depreciate Property

Form (and Instructions)

  • 4562
    Depreciation and Amortization

  • 6251
    Alternative Minimum Tax—Individuals

  • 8582
    Passive Activity Loss Limitations

  • Schedule E (Form 1040)
    Supplemental Income and Loss

Rental Income

You generally must include in your gross income all amounts you receive as rent. Rental income is any payment you receive for the use or occupation of property. In addition to amounts you receive as normal rent payments, there are other amounts that may be rental income.

When to report.   If you are a cash basis taxpayer, report rental income on your return for the year you actually or constructively receive it. You are a cash basis taxpayer if you report income in the year you receive it, regardless of when it was earned. You constructively receive income when it is made available to you, for example, by being credited to your bank account.

  For more information about when you constructively receive income, see Accounting Methods in chapter 1.

Advance rent.   Advance rent is any amount you receive before the period that it covers. Include advance rent in your rental income in the year you receive it regardless of the period covered or the method of accounting you use.

Example.

You sign a 10-year lease to rent your property. In the first year, you receive $5,000 for the first year's rent and $5,000 as rent for the last year of the lease. You must include $10,000 in your income in the first year.

Security deposits.   Do not include a security deposit in your income when you receive it if you plan to return it to your tenant at the end of the lease. But if you keep part or all of the security deposit during any year because your tenant does not live up to the terms of the lease, include the amount you keep in your income for that year.

  If an amount called a security deposit is to be used as a final payment of rent, it is advance rent. Include it in your income when you receive it.

Payment for canceling a lease.   If your tenant pays you to cancel a lease, the amount you receive is rent. Include the payment in your income in the year you receive it regardless of your method of accounting.

Expenses paid by tenant.   If your tenant pays any of your expenses, the payments are rental income. You must include them in your income. You can deduct the expenses if they are deductible rental expenses. See Rental Expenses, later, for more information.

Property or services.   If you receive property or services, instead of money, as rent, include the fair market value of the property or services in your rental income.

  If the services are provided at an agreed upon or specified price, that price is the fair market value unless there is evidence to the contrary.

Rental of property also used as a home.   If you rent property that you also use as your home and you rent it fewer than 15 days during the tax year, do not include the rent you receive in your income and do not deduct rental expenses. However, you can deduct on Schedule A (Form 1040) the interest, taxes, and casualty and theft losses that are allowed for nonrental property. See Personal Use of Dwelling Unit (Including Vacation Home), later.

Part interest.   If you own a part interest in rental property, you must report your part of the rental income from the property.

Rental Expenses

This part discusses repairs and certain other expenses of renting property that you ordinarily can deduct from your rental income. It includes information on the expenses you can deduct if you rent part of your property, or if you change your property to rental use. Depreciation, which you can also deduct from your rental income, is discussed later.

When to deduct.   You generally deduct your rental expenses in the year you pay them.

Vacant rental property.   If you hold property for rental purposes, you may be able to deduct your ordinary and necessary expenses (including depreciation) for managing, conserving, or maintaining the property while the property is vacant. However, you cannot deduct any loss of rental income for the period the property is vacant.

Pre-rental expenses.   You can deduct your ordinary and necessary expenses for managing, conserving, or maintaining rental property from the time you make it available for rent.

Depreciation.   You can begin to depreciate rental property when it is ready and available for rent. See Placed-in-Service Date under Depreciation, later.

Expenses for rental property sold.   If you sell property you held for rental purposes, you can deduct the ordinary and necessary expenses for managing, conserving, or maintaining the property until it is sold.

Personal use of rental property.   If you sometimes use your rental property for personal purposes, you must divide your expenses between rental and personal use. Also, your rental expense deductions may be limited. See Personal Use of Dwelling Unit (Including Vacation Home), later.

Part interest.   If you own a part interest in rental property, you can deduct your part of the expenses that you paid.

Repairs and Improvements

You can deduct the cost of repairs to your rental property. You cannot deduct the cost of improvements. You recover the cost of improvements by taking depreciation (explained later).

Records you should keep
Separate the costs of repairs and improvements, and keep accurate records. You will need to know the cost of improvements when you sell or depreciate your property.

Repairs.   A repair keeps your property in good operating condition. It does not materially add to the value of your property or substantially prolong its life. Repainting your property inside or out, fixing gutters or floors, fixing leaks, plastering, and replacing broken windows are examples of repairs.

  If you make repairs as part of an extensive remodeling or restoration of your property, the whole job is an improvement.

Improvements.   An improvement adds to the value of property, prolongs its useful life, or adapts it to new uses. Improvements include the following items.
  • Putting a recreation room in an unfinished basement.

  • Paneling a den.

  • Adding a bathroom or bedroom.

  • Putting decorative grillwork on a balcony.

  • Putting up a fence.

  • Putting in new plumbing or wiring.

  • Putting in new cabinets.

  • Putting on a new roof.

  • Paving a driveway.

   If you make an improvement to property, the cost of the improvement must be capitalized. The capitalized cost can generally be depreciated as if the improvement were separate property.

Other Expenses

Other expenses you can deduct from your rental income include advertising, cleaning and maintenance services, utilities, fire and liability insurance, taxes, interest, commissions for the collection of rent, ordinary and necessary travel and transportation, and other expenses, discussed next.

Rental payments for property.   You can deduct the rent you pay for property that you use for rental purposes. If you buy a leasehold for rental purposes, you can deduct an equal part of the cost each year over the term of the lease.

Rental of equipment.   You can deduct the rent you pay for equipment that you use for rental purposes. However, in some cases, lease contracts are actually purchase contracts. If so, you cannot deduct these payments. You can recover the cost of purchased equipment through depreciation.

Insurance premiums paid in advance.   If you pay an insurance premium for more than one year in advance, each year you can deduct the part of the premium payment that will apply to that year. You cannot deduct the total premium in the year you pay it.

Local benefit taxes.   Generally, you cannot deduct charges for local benefits that increase the value of your property, such as charges for putting in streets, sidewalks, or water and sewer systems. These charges are nondepreciable capital expenditures. You must add them to the basis of your property. You can deduct local benefit taxes if they are for maintaining, repairing, or paying interest charges for the benefits.

Travel expenses.   You can deduct the ordinary and necessary expenses of traveling away from home if the primary purpose of the trip was to collect rental income or to manage, conserve, or maintain your rental property. You must properly allocate your expenses between rental and nonrental activities. For information on travel expenses, see chapter 28.

  
Records you should keep
To deduct travel expenses, you must keep records that follow the rules in chapter 28.

Local transportation expenses.    You can deduct your ordinary and necessary local transportation expenses if you incur them to collect rental income or to manage, conserve, or maintain your rental property.

  Generally, if you use your personal car, pickup truck, or light van for rental activities, you can deduct the expenses using one of two methods: actual expenses or the standard mileage rate. For 2004, the standard mileage rate for all business miles is 37½ cents a mile. For more information, see chapter 28.

  
Records you should keep
To deduct car expenses under either method, you must keep records that follow the rules in chapter 28. In addition, you must complete Form 4562, Part V, and attach it to your tax return.

Tax return preparation.   You can deduct, as a rental expense, the part of the tax return preparation fees you paid to prepare of Schedule E (Form 1040), Part 1. You can also deduct, as a rental expense, any expense you paid to resolve a tax underpayment related to your rental activities. On your 2004 Schedule E, you can deduct fees paid in 2004 to prepare your 2003 Schedule E, Part I.

Not Rented for Profit

If you do not rent your property to make a profit, you can deduct your rental expenses only up to the amount of your rental income. You cannot carry forward to the next year any rental expenses that are more than your rental income for the year. For more information about the rules for an activity not engaged in for profit, see chapter 1 of Publication 535.

Where to report.   Report your not-for-profit rental income on Form 1040, line 21. You can include your mortgage interest (if you use the property as your main home or second home), real estate taxes, and casualty losses on the appropriate lines of Form 1040, Schedule A, Itemized Deductions, if you itemize your deductions.

  Claim your other rental expenses, subject to the rules explained in chapter 1 of Publication 535, as miscellaneous itemized deductions on Form 1040, Schedule A, line 22. You can deduct these expenses only if they, together with certain other miscellaneous itemized deductions, total more than 2% of your adjusted gross income.

Property Changed to Rental Use

If you change your home or other property, (or a part of it), to rental use at any time other than at the beginning of your tax year, you must divide yearly expenses, such as taxes and insurance, between rental use and personal use.

You can deduct as rental expenses only the part of the expense that is for the part of the year the property was used or held for rental purposes.

For depreciation purposes, treat the property as being placed in service on the conversion date.

You cannot deduct depreciation or insurance for the part of the year the property was held for personal use. However, you can include the home mortgage interest and real estate tax expenses for the part of the year the property was held for personal use as an itemized deduction on Schedule A (Form 1040).

Example.

Your tax year is the calendar year. You moved from your home in May and started renting it on June 1. You can deduct as rental expenses seven-twelfths of your yearly expenses, such as taxes and insurance.

Starting with June, you can deduct as rental expenses the amounts you pay for items generally billed monthly, such as utilities.

Renting Part of Property

If you rent part of your property, you must divide certain expenses between the part of the property used for rental purposes and the part of the property used for personal purposes, as though you actually had two separate pieces of property.

You can deduct the expenses related to the part of the property used for rental purposes, such as home mortgage interest and real estate taxes, as rental expenses on Schedule E (Form 1040). You can also deduct as a rental expense a part of other expenses that normally are nondeductible personal expenses, such as expenses for electricity or painting the outside of your house.

You can deduct the expenses for the part of the property used for personal purposes, subject to certain limitations, only if you itemize your deductions on Schedule A (Form 1040).

You cannot deduct any part of the cost of the first phone line even if your tenants have unlimited use of it.

You do not have to divide the expenses that belong only to the rental part of your property. For example, if you paint a room that you rent, or if you pay premiums for liability insurance in connection with renting a room in your home, your entire cost is a rental expense. If you install a second phone line strictly for your tenants' use, all of the cost of the second line is deductible as a rental expense. You can deduct depreciation, discussed later, on the part of the property used for rental purposes as well as on the furniture and equipment you use for rental purposes.

How to divide expenses.   If an expense is for both rental use and personal use, such as mortgage interest or heat for the entire house, you must divide the expense between the rental use and the personal use. You can use any reasonable method for dividing the expense. It may be reasonable to divide the cost of some items (for example, water) based on the number of people using them. However, the two most common methods for dividing an expense are one based on the number of rooms in your home and one based on the square footage of your home.

Personal Use of Dwelling Unit (Including Vacation Home)

If you have any personal use of a dwelling unit (including a vacation home) that you rent, you must divide your expenses between rental use and personal use. See Figuring Days of Personal Use and How To Divide Expenses, later.

If you used your dwelling unit for personal purposes, it may be considered a “dwelling unit used as a home.” If it is, you cannot deduct rental expenses that are more than your rental income for the unit. See Dwelling Unit Used as Home and How To Figure Rental Income and Deductions, later. If your dwelling unit is not considered a dwelling unit used as a home, you can deduct rental expenses that are more than rental income for the unit subject to certain limits. See Limits on Rental Losses, later.

Exception for minimal rental use.   If you use the dwelling unit as a home and you rent it fewer than 15 days during the year, do not include any of the rent in your income and do not deduct any of the rental expenses. See Dwelling Unit Used as Home, later.

Dwelling unit.    A dwelling unit includes a house, apartment, condominium, mobile home, boat, vacation home, or similar property. A dwelling unit has basic living accommodations, such as sleeping space, a toilet, and cooking facilities. A dwelling unit does not include property used solely as a hotel, motel, inn, or similar establishment.

   Property is used solely as a hotel, motel, inn, or similar establishment if it is regularly available for occupancy by paying customers and is not used by an owner as a home during the year.

Example.

You rent a room in your home that is always available for short-term occupancy by paying customers. You do not use the room yourself, and you allow only paying customers to use the room. The room is used solely as a hotel, motel, inn, or similar establishment and is not a dwelling unit.

Dwelling Unit Used as Home

The tax treatment of rental income and expenses for a dwelling unit that you also use for personal purposes depends on whether you use it as a home. (See How To Figure Rental Income and Deductions, later.)

You use a dwelling unit as a home during the tax year if you use it for personal purposes more than the greater of:

  1. 14 days, or

  2. 10% of the total days it is rented to others at a fair rental price.

See Figuring Days of Personal Use, later.

If a dwelling unit is used for personal purposes on a day it is rented at a fair rental price, do not count that day as a day of rental use in applying (2) above. Instead, count it as a day of personal use in applying both (1) and (2) above. This rule does not apply when dividing expenses between rental and personal use.

Fair rental price.   A fair rental price for your property generally is an amount that a person who is not related to you would be willing to pay. The rent you charge is not a fair rental price if it is substantially less than the rents charged for other properties that are similar to your property.

Examples

The following examples show how to determine whether you used your rental property as a home.

Example 1.

You converted the basement of your home into an apartment with a bedroom, a bathroom, and a small kitchen. You rented the basement apartment at a fair rental price to college students during the regular school year. You rented to them on a 9-month lease (273 days). You figured 10% of the total days rented to others at a fair rental price is 27 days.

During June (30 days), your brother stayed with you and lived in the basement apartment rent free.

Your basement apartment was used as a home because you used it for personal purposes for 30 days. Rent-free use by your brother is considered personal use. Your personal use (30 days) is more than the greater of 14 days or 10% of the total days it was rented (27 days).

Example 2.

You rented the guest bedroom in your home at a fair rental price during the local college's homecoming, commencement, and football weekends (a total of 27 days). Your sister-in-law stayed in the room, rent free, for the last 3 weeks (21 days) in July. You figured 10% of the total days rented to others at a fair rental price is 3 days.

The room was used as a home because you used it for personal purposes for 21 days. That is more than the greater of 14 days or 10% of the 27 days it was rented (3 days).

Example 3.

You own a condominium apartment in a resort area. You rented it at a fair rental price for a total of 170 days during the year. For 12 of those days, the tenant was not able to use the apartment and allowed you to use it even though you did not refund any of the rent. Your family actually used the apartment for 10 of those days. Therefore, the apartment is treated as having been rented for 160 (170 - 10) days. You figure 10% of the total days rented to others at a fair rental price is 16 days. Your family also used the apartment for 7 other days during the year.

You used the apartment as a home because you used it for personal purposes for 17 days. That is more than the greater of 14 days or 10% of the 160 days it was rented (16 days).

Use As Main Home Before or After Renting

For purposes of determining whether a dwelling unit was used as a home, you may not have to count days you used the property as your main home before or after renting it or offering it for rent as days of personal use if:

  • You rented or tried to rent the property for 12 or more consecutive months.

  • You rented or tried to rent the property for a period of less than 12 consecutive months and the period ended because you sold or exchanged the property.

This special rule does not apply when dividing expenses between rental and personal use.

Figuring Days of Personal Use

A day of personal use of a dwelling unit is any day that the unit is used by any of the following persons.

  1. You or any other person who has an interest in it, unless you rent it to another owner as his or her main home under a shared equity financing agreement (defined later).

  2. A member of your family or a member of the family of any other person who has an interest in it, unless the family member uses the dwelling unit as his or her main home and pays a fair rental price. Family includes only brothers and sisters, half-brothers and half-sisters, spouses, ancestors (parents, grandparents, etc.) and lineal descendants (children, grandchildren, etc.).

  3. Anyone under an arrangement that lets you use some other dwelling unit.

  4. Anyone at less than a fair rental price.

Main home.   If the other person or member of the family in (1) or (2) above has more than one home, his or her main home is ordinarily the one he or she lived in most of the time.

Shared equity financing agreement.   This is an agreement under which two or more persons acquire undivided interests for more than 50 years in an entire dwelling unit, including the land, and one or more of the co-owners is entitled to occupy the unit as his or her main home upon payment of rent to the other co-owner or owners.

Donation of use of property.   You use a dwelling unit for personal purposes if:
  • You donate the use of the unit to a charitable organization,

  • The organization sells the use of the unit at a fund-raising event, and

  • The “purchaser” uses the unit.

Examples

The following examples show how to determine days of personal use.

Example 1.

You and your neighbor are co-owners of a condominium at the beach. You rent the unit to vacationers whenever possible. The unit is not used as a main home by anyone. Your neighbor uses the unit for 2 weeks every year.

Because your neighbor has an interest in the unit, both of you are considered to have used the unit for personal purposes during those 2 weeks.

Example 2.

You and your neighbors are co-owners of a house under a shared equity financing agreement. Your neighbors live in the house and pay you a fair rental price.

Even though your neighbors have an interest in the house, the days your neighbors live there are not counted as days of personal use by you. This is because your neighbors rent the house as their main home under a shared equity financing agreement.

Example 3.

You own a rental property that you rent to your son. Your son has no interest in this property. He uses it as his main home. He pays you a fair rental price for the property.

Your son's use of the property is not personal use by you because your son is using it as his main home, he has no interest in the property, and he is paying you a fair rental price.

Example 4.

You rent your beach house to Joshua. Joshua rents his house in the mountains to you. You each pay a fair rental price.

You are using your house for personal purposes on the days that Joshua uses it because your house is used by Joshua under an arrangement that allows you to use his house.

Days Used for Repairs and Maintenance

Any day that you spend working substantially full time repairing and maintaining your property is not counted as a day of personal use. Do not count such a day as a day of personal use even if family members use the property for recreational purposes on the same day.

How To Divide Expenses

If you use a dwelling unit for both rental and personal purposes, divide your expenses between the rental use and the personal use based on the number of days used for each purpose. You can deduct expenses for the rental use of the unit under the rules explained in How To Figure Rental Income and Deductions, later.

When dividing your expenses follow these rules.

  • Any day that the unit is rented at a fair rental price is a day of rental use even if you used the unit for personal purposes that day. This rule does not apply when determining whether you used the unit as a home.

  • Any day that the unit is available for rent but not actually rented is not a day of rental use.

Example.

Your beach cottage was available for rent from June 1 through August 31 (92 days). Your family uses the cottage during the last 2 weeks in May (14 days). You were unable to find a renter for the first week in August (7 days). The person who rented the cottage for July allowed you to use it over a weekend (2 days) without any reduction in or refund of rent. The cottage was not used at all before May 17 or after August 31.

You figure the part of the cottage expenses to treat as rental expenses as follows.

  1. The cottage was used for rental a total of 85 days (92 - 7). The days it was available for rent but not rented (7 days) are not days of rental use. The July weekend (2 days) you used it is rental use because you received a fair rental price for the weekend.

  2. You used the cottage for personal purposes for 14 days (the last 2 weeks in May).

  3. The total use of the cottage was 99 days (14 days personal use + 85 days rental use).

  4. Your rental expenses are 85/99 (86%) of the cottage expenses.

When determining whether you used the cottage as a home, the July weekend (2 days) you used it is personal use even though you received a fair rental price for the weekend. Therefore, you had 16 days of personal use and 83 days of rental use for this purpose. Because you used the cottage for personal purposes more than 14 days and more than 10% of the days of rental use (8 days), you used it as a home. If you have a net loss, you may not be able to deduct all of the rental expenses. See Property Used as a Home in the following discussion.

How To Figure Rental Income and Deductions

How you figure your rental income and deductions depends on whether you used the dwelling unit as a home (see Dwelling Unit Used as Home, earlier) and, if you used it as a home, how many days the property was rented at a fair rental price.

Property Not Used as a Home

If you do not use a dwelling unit as a home, report all the rental income and deduct all the rental expenses. See How To Report Rental Income and Expenses, later.

Your deductible rental expenses can be more than your gross rental income. However, see Limits on Rental Losses, later.

Property Used as a Home

If you use a dwelling unit as a home during the year (see Dwelling Unit Used as Home, earlier), how you figure your rental income and deductions depends on how many days the unit was rented at a fair rental price.

Rented fewer than 15 days.   If you use a dwelling unit as a home and you rent it fewer than 15 days during the year, do not include any rental income in your income. Also, you cannot deduct any expenses as rental expenses.

Rented 15 days or more.   If you use a dwelling unit as a home and rent it 15 days or more during the year, you include all your rental income in your income. See How To Report Rental Income and Expenses, later. If you had a net profit from the rental property for the year (that is, if your rental income is more than the total of your rental expenses, including depreciation), deduct all of your rental expenses. However, if you had a net loss, your deduction for certain rental expenses is limited.

  Use Worksheet 10-1 to figure your deductible expenses.

Depreciation

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

Three basic factors determine how much depreciation you can deduct. They are: (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 How To Report Rental Income and Expenses, later.

Claiming the correct amount of depreciation.   You should claim the correct amount of depreciation each tax year. Even if you did not claim depreciation that you were entitled to deduct, you must still reduce your basis in the property by the full amount of depreciation that you could have deducted. If you did not deduct the correct amount of depreciation for property in any year, you may be able to make a correction for that year by filing Form 1040X, Amended U.S Individual Income Tax Return. If you are not allowed to make the correction on an amended return, you can change your accounting method to claim the correct amount of depreciation. See Claiming the correct amount of depreciation in Publication 527 for more information.

Changing your accounting method to deduct unclaimed depreciation.   To change your accounting method, you must file Form 3115, Application for Change in Accounting Method, to get the consent of the IRS. In some instances, you can receive automatic consent. For more information, see chapter 1 of Publication 946.

Land.   You can never depreciate the cost of land because land does not wear out, become obsolete, or get used up. The costs of clearing, grading, planting, and landscaping are usually all part of the cost of land and cannot be depreciated.

Depreciation Methods

There are three ways to figure depreciation. The depreciation method you use depends on the type of property and when it was placed in service. For property used in rental activities you use one of the following.

  • MACRS (Modified Accelerated Cost Recovery System) for property placed in service after 1986.

  • ACRS (Accelerated Cost Recovery System) for property placed in service after 1980 but before 1987.

  • Useful lives and either straight line or an accelerated method of depreciation, such as the declining balance method, for property placed in service before 1981.

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

If you placed property in service before 2004, continue to use the same method of figuring depreciation that you used in the past.

Section 179 election.   You cannot claim the section 179 deduction for property held to produce rental income. See chapter 2 of Publication 946.

No deduction greater than basis.   The total of all your yearly depreciation deductions cannot be more than the cost or other basis of the property. For this purpose, your yearly depreciation deductions include any depreciation that you were allowed to claim, even if you did not claim it.

Cooperative apartments.   If you are a tenant-stockholder in a cooperative housing corporation and rent your cooperative apartment to others, you can deduct depreciation for your stock in the corporation. Your depreciation deduction is your share of the corporation's depreciation. See Cooperative apartments in Publication 527 for information on how to figure your depreciation deduction.

Special Depreciation Allowance

You can claim a special depreciation allowance (in addition to your regular MACRS depreciation deduction) for qualified property you placed in service in 2004. The allowance is 50% of the property's depreciable basis. You figure the special depreciation allowance before you figure your regular MACRS deduction.

Electing to claim a lower or no special depreciation allowance.   You can elect, for any class of property, to deduct the 30% (instead of 50%) special allowance for all property in such class placed in service during the tax year. Or, you can elect not to deduct any special allowance for all property in such class placed in service during the tax year.

Qualified property.   To qualify for the special depreciation allowance, your property must meet the following requirements.
  1. It must be new property that is depreciated under MACRS with a recovery period of 20 years or less.

  2. It must meet the following tests.

    1. Acquisition date test.

    2. Placed-in-service date test.

    3. Original use test.

Acquisition date test.   Generally, you must have acquired the property after September 10, 2001 (after May 5, 2003, to be eligible for the 50% special depreciation allowance).

Placed-in-service date test.   Generally, the property must be placed in service for use in your trade or business or for the production of income after September 10, 2001 (after May 5, 2003, to be eligible for the 50% special depreciation allowance), and before January 1, 2005.

Original use test.   The original use of the property must have begun with you after September 10, 2001 (after May 5, 2003, to be eligible for the 50% special depreciation allowance). “Original use” means the first use to which the property is put, whether or not by you.

Example.

Dave bought and placed in service a new refrigerator ($700) for one of his residential rental properties in 2004. Dave notes that the refrigerator has a 5-year recovery period (see Table 10-1). Dave's refrigerator is qualifying property and he claims the 50% special depreciation allowance.

Dave determines the total depreciable basis of the property to be $700. Next, he multiplies this amount by 50% to figure his special depreciation allowance deduction of $350 ($700 × 50%). This leaves an adjusted basis of $350 ($700 - $350), which he will use to figure his MACRS deduction.

For more information, see Special Depreciation Allowance in Publication 946.

MACRS

Most business and investment property placed in service after 1986 is depreciated using MACRS.

MACRS consists of two systems that determine how you depreciate your property—the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). GDS is used to figure your depreciation deduction for property used in most rental activities, unless you elect ADS.

To figure your MACRS deduction, you need to know the following information about your property:

  • Its recovery period,

  • Its placed-in-service date, and

  • Its depreciable basis.

Personal home changed to rental use.   You must use MACRS to figure the depreciation on property you used as your home and changed to rental property in 2004.

Excluded property.   You cannot use MACRS for certain personal property placed in service in your rental property in 2004 if it had been previously placed in service before MACRS became effective.

   In addition, you may elect to exclude certain property from the application of MACRS. See Publication 946 for more information.

Recovery Periods Under GDS

Each item of property that can be depreciated is assigned to a property class. The recovery period of the property depends on the class the property is in. Under GDS, the recovery period of an asset is generally the same as its property class. The property classes under GDS are:

  • 3-year property,

  • 5-year property,

  • 7-year property,

  • 10-year property,

  • 15-year property,

  • 20-year property,

  • Nonresidential real property, and

  • Residential rental property.

Recovery periods for property used in rental activities are shown in Table 10-1.

The class to which property is assigned is determined by its class life. Class lives and recovery periods for most assets are listed in Appendix B in Publication 946.

Additions or improvements to property.   Treat depreciable additions or improvements you make to any property as separate property items for depreciation purposes. The recovery period for an addition or improvement to property begins on the later of:
  • The date the addition or improvement is placed in service, or

  • The date the property to which the addition or improvement was made is placed in service.

  The property class and recovery period of the addition or improvement is the one that would apply to the original property if it were placed in service at the same time as the addition or improvement.

Example.

You own a residential rental house that you have been renting since 1986 and that you are depreciating under ACRS. You put an addition onto the house and you placed it in service in 2004. You must use MACRS for the addition. Under GDS, the addition is depreciated as residential rental property over 27.5 years.

Placed-in-Service Date

You can begin to depreciate property when you place it in service in your trade or business or for the production of income. Property is considered placed in service in a rental activity when it is ready and available for a specific use in that activity.

Depreciable Basis

To deduct the proper amount of depreciation each year, you must first determine your basis in the property you intend to depreciate. The basis used for figuring depreciation is your original basis in the property increased by any additions or improvements made to the property. Your original basis is usually your cost. However, if you acquire the property in some other way, such as by inheriting it, getting it as a gift, or building it yourself, you may have to figure your original basis in another way. Other adjustments could also affect your basis. See chapter 14.

Conventions

Under MACRS, conventions establish when the recovery period begins and ends. The convention you use determines the number of months for which you can claim depreciation in the year you place property in service and in the year you dispose of the property.

Mid-month convention.    A mid-month convention is used for all residential rental property and nonresidential real property. Under this convention, you treat all property placed in service, or disposed of, during any month as placed in service, or disposed of, at the midpoint of that month.

Mid-quarter convention.   A mid-quarter convention must be used if the mid-month convention does not apply and the total depreciable basis of MACRS property you placed in service in the last 3 months of a tax year (excluding nonresidential real property, residential rental property, and property placed in service and disposed of in the same year) is more than 40% of the total basis of all such property you place in service during the tax year.

Half-year convention.   The half-year convention is used if neither the mid-quarter convention nor the mid-month convention applies. Under this convention, you treat all property placed in service, or disposed of, during a tax year as placed in service, or disposed of, at the midpoint of that tax year.

  If this convention applies, you deduct a half-year of depreciation for the first year and the last year that you depreciate the property. You deduct a full year of depreciation for any other year during the recovery period.

Table 10-1. MACRS Recovery Periods for Property Used in Rental Activities

  MACRS Recovery Period  
Type of Property General
Depreciation
System
Alternative
Depreciation
System
 
Computers and their peripheral equipment 5 years 5 years  
Office machinery, such as:
Typewriters
Calculators
Copiers
5 years 6 years  
Automobiles 5 years 5 years  
Light trucks 5 years 5 years  
Appliances, such as:
Stoves
Refrigerators
5 years 9 years  
Carpets 5 years 9 years  
Furniture used in rental property 5 years 9 years  
Office furniture and equipment, such as:
Desks
Files
7 years 10 years  
Any property that does not have a class life and that has not
been designated by law as being in any other class
7 years 12 years  
Roads 15 years 20 years  
Shrubbery 15 years 20 years  
Fences 15 years 20 years  
Residential rental property (buildings or structures)
and structural components such as furnaces,
water pipes, venting, etc.,
27.5 years 40 years  
Additions and improvements, such as a new roof The same recovery period as that of the property to which the addition or improvement is made, determined as if the property were placed in service at the same time as the addition or improvement.  
  Under this convention, you treat all property placed in service, or disposed of, during any quarter of a tax year as placed in service, or disposed of, at the midpoint of the quarter.

Example.

During the tax year, Jordan Gregory purchased the following items to use in his rental property. He elects not to claim the special depreciation allowance, discussed earlier.

  • A dishwasher for $400, that he placed in service in January.

  • Used furniture for $100, that he placed in service in September.

  • A refrigerator for $500, that he placed in service in October.

Jordan uses the calendar year as his tax year. The total basis of all property placed in service in that year is $1,000. The $500 basis of the refrigerator placed in service during the last 3 months of his tax year exceeds $400 (40% × $1,000). Jordan must use the mid-quarter convention instead of the half-year convention for all three items.

MACRS Depreciation Under GDS

You can figure your MACRS depreciation deduction under GDS in one of two ways. The deduction is substantially the same both ways. (The difference, if any, is slight.) You can either:

  • Use the percentage from the optional MACRS tables, see Table 10-2, or

  • Actually figure the deduction using the depreciation method and convention that apply over the recovery period of the property.

Publication 946 discusses computing depreciation using the proper method and convention.

Table 10-2. Optional MACRS Tables Table 10-2-A. MACRS 5-Year property

  Half-year convention Mid-quarter convention
Year   First quarter Second quarter Third quarter Fourth quarter
1
2
3
4
5
6
20.00%
32.00
19.20
11.52
11.52
5.76
35.00%
26.00
15.60
11.01
11.01
1.38
25.00%
30.00
18.00
11.37
11.37
4.26
15.00%
34.00
20.40
12.24
11.30
7.06
5.00%
38.00
22.80
13.68
10.94
9.58

Table 10-2-B. MACRS 7-Year property

  Half-year convention Mid-quarter convention
Year   First quarter Second quarter Third quarter Fourth quarter
1
2
3
4
5
6
14.29%
24.49
17.49
12.49
8.93
8.92
25.00%
21.43
15.31
10.93
8.75
8.74
17.85%
23.47
16.76
11.97
8.87
8.87
10.71%
25.51
18.22
13.02
9.30
8.85
3.57%
27.55
19.68
14.06
10.04
8.73

Table 10-2-C. MACRS 15-Year property

  Half-year convention Mid-quarter convention
Year   First
quarter
Second quarter Third quarter Forth quarter
1
2

3

4

5

6
  5.00%
9.50
8.55
7.70
6.93
6.23
  8.75%
9.13
8.21
7.39
6.65
5.99
  6.25%
9.38
8.44
7.59
6.83
6.15
  3.75%
9.63
8.66
7.80
7.02
6.31
  1.25%
9.88
8.89
8.00
7.20
6.48

Table 10-2-D. Residential Rental Property (27.5-year)

    Use the row for the month of the taxable year placed in service.
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
  Jan.
Feb.
Mar.
Apr.
May

Jun.
Jul.
Aug.
Sept.
Oct.

Nov.
Dec.
  3.485%
3.182
2.879
2.576
2.273

1.970
1.667
1.364
1.061
0.758

0.456
0.152
  3.636%
3.636
3.636
3.636
3.636

3.636
3.636
3.636
3.636
3.636

3.636
3.636
  3.636%
3.636
3.636
3.636
3.636

3.636
3.636
3.636
3.636
3.636

3.636
3.636
  3.636%
3.636
3.636
3.636
3.636

3.636
3.636
3.636
3.636
3.636

3.636
3.636
  3.636%
3.636
3.636
3.636
3.636

3.636
3.636
3.636
3.636
3.636

3.636
3.636
  3.636%
3.636
3.636
3.636
3.636

3.636
3.636
3.636
3.636
3.636

3.636
3.636

Using the Optional Tables

You can use the tables in Table 10-2 to compute annual depreciation under MACRS. The tables show the percentages for the first 6 years. The percentages in Tables 10-2-A, 10-2-B, and 10-2-C make the change from declining balance to straight line in the year that straight line will yield a larger deduction. See Appendix A of Publication 946 for complete tables.

If you elect to use the straight line method for 5-, 7-, or 15-year property, or the 150% declining balance method for 5- or 7-year property, use the tables in Appendix A of Publication 946.

Caution
Figure any special depreciation allowance on qualified property before using Table 10-2-A, 10-2-B, or 10-2-C, or the 5-, 7-, or 15-year property tables in Appendix A of Publication 946.

How to use the tables.   The following section explains how to use the optional tables.

  Figure the depreciation deduction by multiplying your unadjusted basis in the property by the percentage shown in the appropriate table. Your unadjusted basis is your depreciable basis without reduction for MACRS depreciation previously claimed.

  Once you begin using an optional table to figure depreciation, you must continue to use it for the entire recovery period unless there is an adjustment to the basis of your property for a reason other than:
  1. Depreciation allowed or allowable, or

  2. An addition or improvement that is depreciated as a separate item of property.

If there is an adjustment for a reason other than (1) or (2) (for example, because of a deductible casualty loss), you can no longer use the table. For the year of the adjustment and for the remaining recovery period, figure depreciation using the property's adjusted basis at the end of the year and the appropriate depreciation method, as explained in MACRS Depreciation Under GDS in Publication 527.

Tables 10-2-A, 10-2-B, and 10-2-C.   The percentages in these tables take into account the half-year and mid-quarter conventions. Use Table 10-2-A for 5-year property, Table 10-2-B for 7-year property, and Table 10-2-C for 15-year property. Use the percentage in the second column (half-year convention) unless you must use the mid-quarter convention (explained earlier). If you must use the mid-quarter convention, use the column that corresponds to the calendar year quarter in which you placed the property in service.

Example 1.

You purchased a stove and refrigerator and placed them in service in June. Your basis in the stove is $600 and your basis in the refrigerator is $1,000. After figuring the 50% special depreciation allowance your basis in the stove is $300 and your basis in the refrigerator is $500. Both are 5-year property. Using the half-year convention column in Table 10-2-A, you find the depreciation percentage for year 1 is 20%. For that year, your depreciation deduction is $60 ($300 × .20) for the stove and $100 ($500 × .20) for the refrigerator.

For year 2, you find your depreciation percentage is 32%. That year's depreciation deduction will be $96 ($300 × .32) for the stove and $160 ($500 × .32) for the refrigerator.

Example 2.

Assume the same facts as in Example 1, except you buy the refrigerator in October instead of June. You must use the mid-quarter convention to figure depreciation on the stove and refrigerator. The refrigerator was placed in service in the last 3 months of the tax year and its basis ($1,000) is more than 40% of the total basis of all property placed in service during the year ($1,600 × .40 = $640).

Because you placed the refrigerator in service in October, you use the fourth quarter column of Table 10-2-A and find that the depreciation percentage for year 1 is 5%. Your depreciation deduction for the refrigerator (after figuring the special depreciation allowance) is $25 ($500 × .05).

Because you placed the stove in service in June, you use the second quarter column of Table 10-2-A and find that the depreciation percentage for year 1 is 25%. For that year, your depreciation deduction for the stove (after figuring the special depreciation allowance) is $75 ($300 × .25).

Table 10-2-D.   Use this table for residential rental property. Find the row for the month that you placed the property in service. Use the percentages listed for that month to figure your depreciation deduction. The mid-month convention is taken into account in the percentages shown in the table.

Example.

You purchased a single family rental house and placed it in service in February. Your basis in the house is $160,000. Using Table 10-2-D, you find that the percentage for property placed in service in February of year 1 is 3.182%. That year's depreciation deduction is $5,091 ($160,000 × .03182).

MACRS Depreciation Under ADS

If you choose, you can use the ADS method for most property. Under ADS, you use the straight line method of depreciation.

Table 10-1 shows the recovery periods for property used in rental activities that you depreciate under ADS. See Appendix B in Publication 946 for other property. If your property is not listed, it is considered to have no class life. Under ADS, personal property with no class life is depreciated using a recovery period of 12 years.

Use the mid-month convention for residential rental property and nonresidential real property. For all other property, use the half-year or mid-quarter convention.

Election.   For property placed in service during 2004, you choose to use ADS by entering the depreciation on Form 4562, Part III, line 20.

  The election of ADS for one item in a class of property generally applies to all property in that class that is placed in service during the tax year of the election. However, the election applies on a property-by-property basis for residential rental property and nonresidential real property.

  Once you choose to use ADS, you cannot change your election.

Other Rules About Depreciable Property

In addition to the rules about what methods you can use, there are other rules you should be aware of with respect to depreciable property.

Gain from disposition.   If you dispose of depreciable property at a gain, you may have to report, as ordinary income, all or part of the gain. See Publication 544, Sales and Other Dispositions of Assets.

Alternative minimum tax.   If you use accelerated depreciation, you may have to file Form 6251. Accelerated depreciation can be determined under MACRS, ACRS, and any other method that allows you to deduct more depreciation than you could deduct using a straight line method.

Limits on Rental Losses

Rental real estate activities are generally considered passive activities, and the amount of loss you can deduct is limited. Generally, you cannot deduct losses from rental real estate activities unless you have income from other passive activities. However, you may be able to deduct rental losses without regard to whether you have income from other passive activities if you “materially” or “actively” participated in your rental activity. See Passive Activity Limits, later.

Losses from passive activities are first subject to the at-risk rules. At-risk rules limit the amount of deductible losses from holding most real property placed in service after 1986.

Exception.   If your rental losses are less than $25,000 and you actively participated in the rental activity, the passive activity limits probably do not apply to you. See Losses From Rental Real Estate Activities, later.

Property used as a home.   If you used the rental property as a home during the year, the passive activity rules do not apply to that home. Instead, you must follow the rules explained earlier under Personal Use of Dwelling Unit (Including Vacation Home.)

At-Risk Rules

The at-risk rules place a limit on the amount you can deduct as losses from activities often described as tax shelters. Losses from holding real property (other than mineral property) placed in service before 1987 are not subject to the at-risk rules.

Generally, any loss from an activity subject to the at-risk rules is allowed only to the extent of the total amount you have at risk in the activity at the end of the tax year. You are considered at risk in an activity to the extent of cash and the adjusted basis of other property you contributed to the activity and certain amounts borrowed for use in the activity. See Publication 925 for more information.

Passive Activity Limits

In general, all rental activities (except those meeting the exception for real estate professionals, below) are passive activities. For this purpose, a rental activity is an activity from which you receive income mainly for the use of tangible property, rather than for services.

Limits on passive activity deductions and credits.    Deductions for losses from passive activities are limited. You generally cannot offset income, other than passive income, with losses from passive activities. Nor can you offset taxes on income, other than passive income, with credits resulting from passive activities. Any excess loss or credit is carried forward to the next tax year.

  For a detailed discussion of these rules, see Publication 925.

   You may have to complete Form 8582 to figure the amount of any passive activity loss for the current tax year for all activities and the amount of the passive activity loss allowed on your tax return.

Exception for real estate professionals.   Rental activities in which you materially participated during the year are not passive activities if, for that year, you were a real estate professional because you met the requirements. For a detailed discussion of the requirements, see Publication 527. For a detailed discussion of material participation, see Publication 925.

Losses From Rental Real Estate Activities

If you or your spouse actively participated in a passive rental real estate activity, you can deduct up to $25,000 of loss from the activity from your nonpassive income. This special allowance is an exception to the general rule disallowing losses in excess of income from passive activities. Similarly, you can offset credits from the activity against the tax on up to $25,000 of nonpassive income after taking into account any losses allowed under this exception.

If you are married, filing a separate return, and lived apart from your spouse for the entire tax year, your special allowance cannot be more than $12,500. If you lived with your spouse at any time during the year and are filing a separate return, you cannot use the special allowance to reduce your nonpassive income or tax on nonpassive income.

The maximum amount of the special allowance is reduced if your modified adjusted gross income is more than $100,000 ($50,000 if married filing separately).

Active participation.   You actively participated in a rental real estate activity if you (and your spouse) owned at least 10% of the rental property and you made management decisions in a significant and bona fide sense. Management decisions include approving new tenants, deciding on rental terms, approving expenditures, and similar decisions.

More information.   See Publication 925 for more information on the passive loss limits, including information on the treatment of unused disallowed passive losses and credits and the treatment of gains and losses realized on the disposition of a passive activity.

How To Report Rental Income and Expenses

If you rent buildings, rooms, or apartments, and provide only heat and light, trash collection, etc., you normally report your rental income and expenses on Form 1040, Schedule E, Part I. However, do not use that schedule to report a not-for-profit activity. See Not Rented for Profit, earlier.

If you provide significant services that are primarily for your tenant's convenience, such as regular cleaning, changing linen, or maid service, you report your rental income and expenses on Schedule C (Form 1040), Profit or Loss From Business or Schedule C-EZ, Net Profit From Business (Sole Proprietorship). Significant services do not include the furnishing of heat and light, cleaning of public areas, trash collection, etc. For information, see Publication 334, Tax Guide for Small Business (For Individuals Who Use Schedule C or C-EZ). You also may have to pay self-employment tax on your rental income. See Publication 533, Self-Employment Tax.

Form 1098.    If you paid $600 or more of mortgage interest on your rental property to any one person, you should receive a Form 1098, Mortgage Interest Statement, or similar statement showing the interest you paid for the year. If you and at least one other person (other than your spouse if you file a joint return) were liable for, and paid interest on the mortgage, and the other person received the Form 1098, report your share of the interest on Form 1040, Schedule E, line 13. Attach a statement to your return showing the name and address of the other person. In the left margin of Schedule E (Form 1040), next to line 13, enter “See attached.

Schedule E (Form 1040)

Use Form 1040, Schedule E, Part I, to report your rental income and expenses. List your total income, expenses, and depreciation for each rental property. Be sure to answer the question on line 2.

If you have more than three rental or royalty properties, complete and attach as many Schedules E as are needed to list the properties. Complete lines 1 and 2 for each property. However, fill in the “Totals” column on only one Schedule E. The figures in the “Totals” column on that Schedule E should be the combined totals of all Schedules E.

Schedule E, page 2, is used to report income or loss from partnerships, S corporations, estates, trusts, and real estate mortgage investment conduits. If you need to use Schedule E, page 2, use page 2 of the same Schedule E you used to enter the combined totals in Part I.

On Schedule E, page 1, line 20, enter the depreciation you are claiming. You must complete and attach Form 4562 for rental activities only if you are claiming:

  • Depreciation on property placed in service during 2004,

  • Depreciation on listed property (such as a car), regardless of when it was placed in service, or

  • Any car expenses reported on a form other than Schedule C or C-EZ (Form 1040) or Form 2106 or Form 2106-EZ.

Otherwise, figure your depreciation on your own worksheet. You do not have to attach these computations to your return.

Example.

On January 1, Justin Cole bought a townhouse and placed it in service as residential rental property. He receives $1,100 a month rental income. His rental expenses for the year are as follows:

Fire insurance (1-year policy) $ 200
Mortgage interest 5,000
Fee paid to real estate company for
collecting monthly rent
572
General repairs 175
Real estate taxes imposed and paid 800

Justin's basis for depreciation of the townhouse is $150,000. He is using MACRS with a 27.5-year recovery period. On April 1, Justin bought a new refrigerator for the rental property at a cost of $725. He uses the MACRS method with a 5-year recovery period. The refrigerator qualifies for the special depreciation allowance which he figures first.

Justin uses the percentage for January in Table 10-2-D to figure his depreciation deduction for the townhouse. He uses the percentage under “Half-year convention” in Table 10-2-A to figure his depreciation deduction for the refrigerator. He must report the depreciation on Form 4562.

Justin figures his net rental income or loss for the townhouse as follows:

Total rental income received    
($1,100 × 12) $13,200
Minus Expenses:    
Fire insurance (1-year policy) 200  
Mortgage interest 5,000  
Rent collection fee 572  
General repairs 175  
Real estate taxes 800  
Total expenses 6,747
Balance $6,453
Minus Depreciation:    
Townhouse
($150,000 × 3.485%)
5,228  
Refrigerator–special
allowance
($725 × 50%)
363  
Refrigerator ($725 – $363
(special allowance) × 20%)
72  
Total depreciation 5,663
     
Net rental income for townhouse $ 790

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