When you use your property to produce income, such as rents, you can recover (get back) some or all of what you paid for the property through tax deductions. You do this by depreciating the property; that is, by deducting some of your cost on your tax return each year.
Several factors determine how much depreciation you can deduct. The main factors are: (1) your basis in the property, (2) the recovery period for the property, and (3) the depreciation method used.
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. If, in an earlier year, you did not claim depreciation that you were entitled to deduct, you must still reduce your basis in the property by the amount of depreciation that you should have deducted. You generally cannot deduct the unclaimed depreciation in the current year or any later tax year. However, you may be able to claim the correct amount of depreciation on an amended return (Form 1040X) for the earlier year. See Claiming the correct amount of depreciation
in Publication 527 for more information.
Changing your accounting method to deduct unclaimed depreciation.
If you claimed less depreciation than allowable in an earlier year, you can change your accounting method to take a deduction in the current year for the unclaimed depreciation. To change your accounting method, you must have 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 land. The costs of clearing, grading, planting, and landscaping are usually all part of the cost of land and are not depreciable.
Depreciation Systems
There are three ways to figure depreciation. The depreciation system you use depends on the type of property and when the property was placed in service. For property used in rental activities you use:
- Modified Accelerated Cost Recovery Systems (MACRS) if placed in service after 1986.
- Accelerated Cost Recovery Systems (ACRS) if 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, if placed in service before 1981.
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This chapter discusses MACRS only. If you are depreciating property placed in service before 1987, see Publication 534.
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If you placed property in service before 2000, 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 (unless renting property is your trade or business). See chapter 2 of Publication 946.
Cannot be more 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 rent your cooperative apartment to others, you can deduct your share of the cooperative housing corporation’s depreciation. See Cooperative apartments in Publication 527 for information on how to figure your depreciation deduction.
MACRS
In general the modified accelerated cost recovery system (MACRS) applies to all tangible property placed in service during 2000.
MACRS consists of two systems that determine how you depreciate your property. The main system is called the General Depreciation System (GDS). The second system is called the Alternative Depreciation System (ADS). GDS is used to figure your depreciation deduction for property used in most rental activities, unless you elect ADS.
Table 10-2 MACRS Recovery Periods
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 2000.
Excluded property.
You cannot use MACRS for certain personal property placed in service before 1987 (before August 1, 1986, if election made) that is transferred after 1986 (after July 31, 1986, if election made). However, you generally must use MACRS to depreciate property you or a related party used before 1987, or that you acquired from a related party, if the property had previously been depreciated under ACRS and the MACRS deduction would be less than the deduction under ACRS.
In addition, you may elect to exclude certain property from the application of MACRS. See Publication 534 for more information. Property that does not come under MACRS must be depreciated under ACRS or one of the other methods of depreciation, such as straight line or declining balance.
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. The property classes 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 10-2.
The class to which property is assigned is determined by its class life. For more information on class lives and recovery periods, see 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 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 class and recovery period of the addition or improvement is the one that would apply to the underlying 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 out since 1980 and are depreciating under ACRS. If you put an addition onto the house, and you place the improvement in service after 1986, you use MACRS for the addition. Under MACRS, the addition would be depreciated as residential rental property.
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.
Cost 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 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
In the year that you place property in service or in the year that you dispose of property, you are allowed to claim depreciation for only part of the year. The part of the year (or convention) depends on the class of the property.
There are three types of conventions.
- Mid-month convention.
- Half-year convention.
- Mid-quarter convention.
Mid-month convention.
A mid month convention is used for residential rental property in all situations. Under a mid-month convention, residential rental property placed in service, or disposed of, during any month is treated as placed in service, or disposed of, in the middle of that month.
Half-year convention.
The half-year convention is used in rental activities other than residential rental property. The half-year convention treats all property placed in service, or disposed of, during a tax year as placed in service, or disposed of, in the middle of that tax year.
A half year of depreciation is allowable for the first year property is placed in service, regardless of when the property is placed in service during the tax year. For each of the remaining years of the recovery period, you will take a full year of depreciation. If you hold the property for the entire recovery period, a half year of depreciation is allowable for the year in which the recovery period ends. If you dispose of the property before the end of the recovery period, a half year of depreciation is allowable for the year of disposition.
Mid-quarter convention.
A mid-quarter convention must be used in certain circumstances for property used in rental activities, other than residential rental property. This convention applies if the total basis of such property that is placed in service in the last 3 months of a tax year is more than 40% of the total basis of all such property you place in service during the year.
Under a mid-quarter convention, all property placed in service, or disposed of, during any quarter of a tax year is treated as placed in service, or disposed of, in the middle of the quarter.
Do not include in the total basis any property placed in service and disposed of during the same tax year.
Example.
During the tax year, Jordan Gregory purchased the following items to use in his rental property.
- 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 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, 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 10-3 Optional MACRS Tables
Using the Optional Tables
You can use the tables in Table 10-3 to compute annual depreciation under MACRS. The tables show the percentages for the first 6 years. The percentages in Tables 10-3-A, 10-3-B, and 10-3-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.
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 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:
- Depreciation allowed or allowable, or
- An addition or improvement that is depreciated as a separate item of property.
If there is an adjustment for any other reason (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 10-3-A, 10-3-B, and 10-3-C.
The percentages in these tables take into account the half-year and mid-quarter conventions. Use Table 10-3-A for 5-year property, Table 10-3-B for 7-year property, and Table 10-3-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 February. Your basis in the stove is $300, and your basis in the refrigerator is $500. Assume that both are 5-year property. Using the half-year convention column in Table 10-3-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 is $100 ($500 × .20) for the refrigerator.
For the second tax year, 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 February. 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 ($500) is more than 40% of the total basis of all property placed in service during the year ($800 × .40 = $320).
Because you placed the stove in service in February, you use the first quarter column of Table 10-3-A and find that the depreciation percentage for year 1 is 35%. For that year, your depreciation deduction for the stove is $105 ($300 × .35).
Because you placed the refrigerator in service in October, you use the fourth quarter column of Table 10-3-A and find that the depreciation percentage for year 1 is 5%. Your depreciation deduction for the refrigerator is $25 ($500 × .05).
Table 10-3-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 $80,000. Using Table 10-3-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 $2,546 ($80,000 × .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 10-2 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.
Use the mid-month convention for residential rental property. For all other property, use the half-year or mid-quarter convention.
Election.
You choose to use ADS by entering the depreciation on line 16, Part II of Form 4562.
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.
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 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 includes MACRS and ACRS and any other method that allows you to deduct more depreciation than you could deduct using a straight line method.
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