How To Figure Rental Income and Deductions

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

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, how you figure your rental income and deductions depends on how many days the unit was rented.

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.

Limit on deductions.   If your rental expenses are more than your rental income, you cannot use the excess expenses to offset income from other sources. The excess can be carried forward to the next year and treated as rental expenses for the same property. Any expenses carried forward to next year will be subject to any limits that apply next year. You can deduct the expenses carried over to a year only up to the amount of your rental income for that year, even if you do not use the property as your home for that year.

To figure your deductible rental expenses and any carryover to next year, use Table 2.

Table 2

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. Also see Publication 946.

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. See Decreases to basis, later, for more information. 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 Changing your accounting method, later.

Filing an amended return.   You can file an amended return to correct the amount of depreciation claimed for any property in any of the following situations.

• You claimed the incorrect amount because of a mathematical error made in any year.
• You claimed the incorrect amount because of a posting error made in any year.
• You have not adopted a method of accounting for the property.

You have adopted a method of accounting for the property if you deducted an incorrect amount of depreciation for it on two or more consecutively filed tax returns for reasons other than a mathematical or posting error.

If an amended return is allowed, you must file it by the later of the following dates.

• 3 years from the date you filed your original return for the year in which you did not deduct the correct amount. (A return filed early is considered filed on the due date.)
• 2 years from the time you paid your tax for that year.

Changing your accounting method.   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, that consent is automatic. For more information, see Changing Your Accounting Method in Publication 946.

What Property Can be Depreciated

You can depreciate your property if it meets all the following requirements.

• It must be property you own.
• It must be used in your business or income-producing activity (such as rental property).
• It must have a determinable useful life.
• It must be expected to last more than one year.
• It must not be excepted property (such as property placed in service and disposed of in the same year and section 197 intangibles).

Property having a determinable useful life.   To be depreciable, your property must have a determinable useful life. This means that it must be something that wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes.

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 are not depreciable.

Property you own.   To claim depreciation, you usually must be the owner of the property. You are considered as owning property even if it is subject to a debt.

Rented property.   Generally, if you pay rent on property, you cannot depreciate that property. Usually, only the owner can depreciate it. If you make permanent improvements to the property, you may be able to depreciate the improvements. See Additions or improvements to property, later.

Cooperative apartments.   If you are a tenent-stockholder in a cooperative housing corporation and rent your cooperative apartment to others, you can deduct depreciation for your stock in the corporation.

Figure your depreciation deduction as follows.

1. Figure the depreciation for all the depreciable real property owned by the corporation. (Depreciation methods are discussed later.) If you bought your cooperative stock after its first offering, figure the depreciable basis of this property as follows.
   1. Multiply your cost per share by the total number of outstanding shares.
   2. Add to the amount figured in (a) any mortgage debt on the property on the date you bought the stock.
   3. Subtract from the amount figured in (b) any mortgage debt that is not for the depreciable real property, such as the part for the land.
2. Subtract from the amount figured in (1) any depreciation for space owned by the corporation that can be rented but cannot be lived in by tenant-stockholders.
3. Divide the number of your shares of stock by the total number of shares outstanding, including any shares held by the corporation.
4. Multiply the result of (2) by the percentage you figured in (3). This is your depreciation on the stock.

Your depreciation deduction for the year cannot be more than the part of your adjusted basis (defined later) in the stock of the corporation that is allocable to your rental property.

See Cooperative apartments under What Property Can Be Depreciated in chapter 1 of Publication 946 for more information.

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.

Table 3. 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, waterpipes, 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.

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.

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

If you placed property in service before 2002, continue to use the same method of figuring depreciation that you used in the past.

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

Alternative minimum tax.   If you use accelerated depreciation, you may have to file Form 6251, Alternative Minimum Tax - Individuals. 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.

Special Depreciation Allowance

You can claim a special depreciation allowance for qualified property you placed in service after September 10, 2001. The allowance is a depreciation deduction equal to 30% of the property's depreciable basis. The special depreciation allowance is figured before you calculate your regular MACRS deduction.

You should claim the special depreciation allowance for all qualified property. However, you can elect not to claim the allowance. If you make this election for any property, it applies to all property in the same property class placed in service during the year. See How Can You Elect Not To Claim an Allowance? in Publication 946 for more information.

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.

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, and before January 1, 2005.

Original use test.   The original use of the property must have begun with you after September 10, 2001. 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 June of 2002. Dave notes that the refrigerator has a 5-year recovery period (see Table 3). Dave's refrigerator is qualifying property and he claims the special depreciation allowance.

Dave determines the total depreciable basis of the property to be $700. Next, he multiplies this amount by 30% to figure his special depreciation allowance of $210 ($700 × 30%). This leaves an adjusted basis of $490 ($700 - $210), which he will use to figure his MACRS deduction.

For more information, see Claiming the Special Depreciation Allowance (or Liberty Zone 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:

1. Its recovery period,
2. Its placed-in-service date, and
3. Its depreciable basis.

Personal home changed to rental use.   You must use MACRS to figure the depreciation on property used as your home and changed to rental property in 2002.

Excluded property.   You cannot use MACRS for certain personal property placed in service in your rental property in 2002 if it had been previously placed in service before MACRS became effective. Generally, personal property is excluded from MACRS if you (or a person related to you) owned or used it in 1986 or if your tenant is a person (or someone related to the person) who owned or used it in 1986. However, the property is not excluded if your 2002 deduction under MACRS (using a half-year convention) is less than the deduction you would have under ACRS. See Can You Use MACRS To Depreciate Your Property? in 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.

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.

Under GDS, property that you placed in service during 2002 in your rental activities generally falls into one of the following classes. Also see Table 3.

1. 5-year property. This class includes computers and peripheral equipment, office machinery (typewriters, calculators, copiers, etc.), automobiles, and light trucks. This class also includes appliances, carpeting, furniture, etc., used in a residential rental real estate activity. Depreciation on automobiles, certain computers, and cellular telephones is limited. See chapter 5 of Publication 946.
2. 7-year property. This class includes office furniture and equipment (desks, files, etc.). This class also includes any property that does not have a class life and that has not been designated by law as being in any other class.
3. 15-year property. This class includes roads and shrubbery (if depreciable).
4. Residential rental property. This class includes any real property that is a rental building or structure (including a mobile home) for which 80% or more of the gross rental income for the tax year is from dwelling units. It does not include a unit in a hotel, motel, inn, or other establishment where more than half of the units are used on a transient basis. If you live in any part of the building or structure, the gross rental income includes the fair rental value of the part you live in. The recovery period for residential rental property is 27.5 years.

The other property classes do not generally apply to property used in rental activities. These classes are not discussed in this publication. See Publication 946 for more information.

Qualified Indian reservation property.   Shorter recovery periods are provided under MACRS for qualified Indian reservation property placed in service on Indian reservations before 2005. For more information, see chapter 4 of 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:

1. The date the addition or improvement is placed in service, or
2. 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 placed it in service in 2002. 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.

Example 1.   On November 22 of last year, you purchased a dishwasher for your rental property. The appliance was delivered on December 7, but was not installed and ready for use until January 3 of this year. Because the dishwasher was not ready for use last year, it is not considered placed in service until this year.

If the appliance had been ready for use when it was delivered in December of last year, it would have been considered placed in service in December, even if it was not actually used until this year.

Example 2.   On April 6, you purchased a house to use as residential rental property. You made extensive repairs to the house and had it ready for rent on July 5. You began to advertise the house for rent in July and actually rented it beginning September 1. The house is considered placed in service in July when it was ready and available for rent. You can begin to depreciate the house in July.

Example 3.   You moved from your home in July. During August and September you made several repairs to the house. On October 1, you listed the property for rent with a real estate company, which rented it on December 1. The property is considered placed in service on October 1, the date when it was available for rent.

Depreciable Basis

The depreciable basis of property used in a rental activity is generally its adjusted basis when you place it in service in that activity. This is its cost or other basis when you acquired it, adjusted for certain items occurring before you place it in service in the rental activity.

If you depreciate your property under MACRS, you may also have to reduce your basis by certain deductions and credits with respect to the property, including any special depreciation allowance (discussed earlier).

Basis and adjusted basis are explained in the following discussions.

If you used the property for personal purposes before changing it to rental use, its depreciable basis is the lesser of its adjusted basis or its fair market value when you change it to rental use. See Basis of Property Changed to Rental Use, later.

Cost Basis

The basis of property you buy is usually its cost. The cost is the amount you pay for it in cash, in debt obligation, in other property, or in services. Your cost also includes amounts you pay for:

• Sales tax charged on the purchase,
• Freight charges to obtain the property, and
• Installation and testing charges.

Loans with low or no interest.   If you buy property on any time-payment plan that charges little or no interest, the basis of your property is your stated purchase price, less the amount considered to be unstated interest. See Unstated Interest and Original Issue Discount in Publication 537, Installment Sales.

Real property.   If you buy real property, such as a building and land, certain fees and other expenses you pay are part of your cost basis in the property.

Real estate taxes.   If you buy real property and agree to pay real estate taxes on it that were owed by the seller and the seller did not reimburse you, the taxes you pay are treated as part of your basis in the property. You cannot deduct them as taxes paid.

If you reimburse the seller for real estate taxes the seller paid for you, you can usually deduct that amount. Do not include that amount in your basis in the property.

Settlement fees and other costs.   Settlement fees and closing costs that are for buying the property are part of your basis in the property. These include:

• Abstract fees,
• Charges for installing utility services,
• Legal fees,
• Recording fees,
• Surveys,
• Transfer taxes,
• Title insurance, and
• Any amounts the seller owes that you agree to pay, such as back taxes or interest, recording or mortgage fees, charges for improvements or repairs, and sales commissions.

Some settlement fees and closing costs you cannot include in your basis in the property are:

1. Fire insurance premiums,
2. Rent or other charges relating to occupancy of the property before closing, and
3. Charges connected with getting or refinancing a loan, such as:
   1. Points (discount points, loan origination fees),
   2. Mortgage insurance premiums,
   3. Loan assumption fees,
   4. Cost of a credit report, and
   5. Fees for an appraisal required by a lender.

Also, do not include amounts placed in escrow for the future payment of items such as taxes and insurance.

Assumption of a mortgage.   If you buy property and become liable for an existing mortgage on the property, your basis is the amount you pay for the property plus the amount that still must be paid on the mortgage.

Example.   You buy a building for $60,000 cash and assume a mortgage of $240,000 on it. Your basis is $300,000.

Land and buildings.   If you buy buildings and your cost includes the cost of the land on which they stand, you must divide the cost between the land and the buildings to figure the basis for depreciation of the buildings. The part of the cost that you allocate to each asset is the ratio of the fair market value of that asset to the fair market value of the whole property at the time you buy it.

If you are not certain of the fair market values of the land and the buildings, you can divide the cost between them based on their assessed values for real estate tax purposes.

Example.   You buy a house and land for $100,000. The purchase contract does not specify how much of the purchase price is for the house and how much is for the land.

The latest real estate tax assessment on the property was based on an assessed value of $80,000, of which $68,000 is for the house and $12,000 is for the land.

You can allocate 85% ($68,000 ÷ $80,000) of the purchase price to the house and 15% ($12,000 ÷ $80,000) of the purchase price to the land.

Your basis in the house is $85,000 (85% of $100,000) and your basis in the land is $15,000 (15% of $100,000).

Basis Other Than Cost

There are many times when you cannot use cost as a basis. You cannot use cost as a basis for property that you received:

• In return for services you performed,
• In an exchange for other property,
• As a gift,
• From your spouse, or from your former spouse as the result of a divorce, or
• As an inheritance.

If you received property in one of these ways, see Publication 551 for information on how to figure your basis.

Adjusted Basis

Before you can figure allowable depreciation, you may have to make certain adjustments (increases and decreases) to the basis of the property. The result of these adjustments to the basis is the adjusted basis.

Increases to basis.   You must increase the basis of any property by the cost of all items properly added to a capital account. This includes:

• The cost of any additions or improvements having a useful life of more than one year,
• Amounts spent after a casualty to restore the damaged property,
• The cost of extending utility service lines to the property, and
• Legal fees, such as the cost of defending and perfecting title.

Additions or improvements.   Add to the basis of your property the amount an addition or improvement actually cost you, including any amount you borrowed to make the addition or improvement. This includes all direct costs, such as material and labor, but not your own labor. It also includes all expenses related to the addition or improvement.

For example, if you had an architect draw up plans for remodeling your property, the architect's fee is a part of the cost of the remodeling. Or, if you had your lot surveyed to put up a fence, the cost of the survey is a part of the cost of the fence.

Keep separate accounts for depreciable additions or improvements made after you place the property in service in your rental activity. For information on depreciating additions or improvements, see Additions or improvements to property, earlier, under Recovery Periods Under GDS.

The cost of landscaping improvements is usually treated as an addition to the basis of the land, which is not depreciable. See What property can be depreciated, earlier.

Assessments for local improvements.   Assessments for items which tend to increase the value of property, such as streets and sidewalks, must be added to the basis of the property. For example, if your city installs curbing on the street in front of your house, and assesses you and your neighbors for the cost of curbing, you must add the assessment to the basis of your property. Also add the cost of legal fees paid to obtain a decrease in an assessment levied against property to pay for local improvements. You cannot deduct these items as taxes or depreciate them.

Assessments for maintenance or repair or meeting interest charges are deductible as taxes. Do not add them to your basis in the property.

Deducting vs. capitalizing costs.   You cannot add to your basis costs that are deductible as current expenses. However, there are certain costs you can choose either to deduct or to capitalize. If you capitalize these costs, include them in your basis. If you deduct them, do not include them in your basis.

The costs you may be able to choose to deduct or to capitalize include carrying charges, such as interest and taxes, that you must pay to own property.

For more information about deducting or capitalizing costs, see chapter 8 in Publication 535.

Decreases to basis.   You must decrease the basis of your property by any items that represent a return of your cost. These include:

• The amount of any insurance or other payment you receive as the result of a casualty or theft loss,
• Any deductible casualty loss not covered by insurance,
• Any amount you receive for granting an easement,
• Any residential energy credit you were allowed before 1986, if you added the cost of the energy items to the basis of your home, and
• The amount of depreciation you could have deducted on your tax returns under the method of depreciation you selected. If you took less depreciation than you could have under the method you selected, you must decrease the basis by the amount you could have taken under that method.
  If you deducted more depreciation than you should have, you must decrease your basis by the amount you should have deducted, plus the part of the excess you deducted that actually lowered your tax liability for any year.

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