Basis of Property Changed to Rental Use
When you change property you held for personal use to rental use (for example, you rent your former home), you figure the basis for depreciation using the lesser of fair market value or adjusted basis.
Fair market value. This is the price at which the property would change hands between a buyer and a seller, neither having to buy or sell, and both having reasonable knowledge of all the relevant facts. Sales of similar property, on or about the same date, may be helpful in figuring the fair market value of the property.
Figuring the basis. The basis for depreciation is the lesser of:
- The fair market value of the property on the date you changed it to rental use, or
- Your adjusted basis on the date of the change - that is, your original cost or other basis of the property, plus the cost of permanent additions or improvements since you acquired it, minus deductions for any casualty or theft losses claimed on earlier years' income tax returns and other decreases to basis.
Example. Several years ago you built your home for $140,000 on a lot that cost you $14,000. Before changing the property to rental use last year, you added $28,000 of permanent improvements to the house and claimed a $3,500 deduction for a casualty loss to the house. Because land is not depreciable, you can only include the cost of the house when figuring the basis for depreciation.
The adjusted basis of the house at the time of the change in use was $164,500 ($140,000 + $28,000 - $3,500).
On the date of the change in use, your property had a fair market value of $168,000, of which $21,000 was for the land and $147,000 was for the house.
The basis for depreciation on the house is the fair market value at the date of the change ($147,000), because it is less than your adjusted basis ($164,500).
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:
- Actually compute the deduction using the depreciation method and convention that apply over the recovery period of the property, or
- Use the percentage from the optional MACRS tables, shown later.
If you actually compute the deduction, the depreciation method you use depends on the class of the property.
5-, 7-, or 15-year property. For property in the 5- or 7-year class, use the 200% declining balance method and a half-year convention. However, in limited cases you must use the mid-quarter convention, if it applies. These conventions are explained later. For property in the 15-year class, use the 150% declining balance method and a half-year convention.
You can also choose to use the 150% declining balance method for property in the 5- or 7-year class. The choice to use the 150% method for one item in a class of property applies to all property in that class that is placed in service during the tax year of the election. You make this election on Form 4562. In column (f), Part III, enter 150 DB.
If you use either the 200% or 150% declining balance method, you figure your deduction using the straight line method in the first tax year that the straight line method gives you an equal or larger deduction.
You can also choose to use the straight line method with a half-year or mid-quarter convention for 5-, 7-, or 15-year property. The choice to use the straight line method for one item in a class of property applies to all property in that class that is placed in service during the tax year of the election. You elect the straight line method on Form 4562. In column (f), Part III, enter S/L. Once you make this election, you cannot change to another method.
Residential rental property. You must use the straight line method and a mid-month convention for residential rental property.
Declining Balance Method
To figure your MACRS deduction, first determine your declining balance rate from the table below. However, if you elect to use the 150% declining balance method for 5- or 7-year property, figure the declining balance rate by dividing 1.5 (150%) by the recovery period for the property.
In the first tax year, multiply the adjusted basis of the property by the declining balance rate and apply the appropriate convention to figure your depreciation. In later years (before the year you switch to the straight line method), use the following steps to figure your depreciation.
- Reduce your adjusted basis by the depreciation allowable for the earlier years.
- Multiply the new adjusted basis in (1) by the same rate used in earlier years.
See Conventions, later, for information on depreciation in the year you dispose of property.
Declining balance rates. The following table shows the declining balance rate that applies for each class of property and the first year for which the straight line method will give an equal or greater deduction. (The rates for 5- and 7-year property are based on the 200% declining balance method. The rate for 15-year property is based on the 150% declining balance method.)
| Class |
Declining Balance Rate |
Year |
| 5 |
40% |
4th |
| 7 |
28.57% |
5th |
| 15 |
10% |
7th |
Straight Line Method
To figure your MACRS deduction under the straight line method, you must apply a different depreciation rate to the adjusted basis of your property for each tax year in the recovery period.
In the first year, multiply the adjusted basis of the property by the straight line rate. You must figure the depreciation for the first year using the convention that applies. (See Conventions, later.)
Straight line rate. For any tax year, figure the straight line rate by dividing the number 1 by the years remaining in the recovery period at the beginning of the tax year. When figuring the number of years remaining, you must take into account the convention used in the first year. If the remaining recovery period at the beginning of the tax year is less than one year, the straight line rate for that tax year is 100%.
Example. You place in service property with a basis of $1,000 and a 5-year recovery period. You elect not to claim the special depreciation allowance, discussed earlier. The straight line rate is 20% (1 divided by 5) for the first tax year. After you apply the half-year convention, the first year rate is 10% (20% divided by 2). Depreciation for the first year is $100.
At the beginning of the second year, the remaining recovery period is 4½ years because of the half-year convention. The straight line rate for the second year is 22.22% (1 divided by 4.5).
To figure your depreciation deduction for the second year:
- Subtract the depreciation taken in the first year ($100) from the basis of the property ($1,000), and
- Multiply the remaining basis ($900) by 22.22%. The depreciation for the second year is $200.
Residential rental property. In the first year that you claim depreciation for residential rental property, you can only claim depreciation for the number of months the property is in use, and you must use the mid-month convention (explained under Conventions, next).
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 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 year.
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, Tom Martin 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.
Tom uses the calendar year as his tax year. The total basis of all property placed in service 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). Tom must use the mid-quarter convention instead of the half-year convention for all three items.
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 4
Optional Tables
You can use the tables in Table 4 to compute annual depreciation under MACRS. The tables show the percentages for the first 6 years. See Appendix A of Publication 946 for complete tables. The percentages in Tables 4-A, 4-B, and 4-C make the change from declining balance to straight line in the year that straight line will yield a larger deduction. See Declining Balance Method, earlier.
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.
Figure any special depreciation allowance on qualified property before using Table 4-A, 4-B, and 4-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:
- 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 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 earlier under MACRS Depreciation Under GDS.
Tables 4-A, 4-B, and 4-C. The percentages in these tables take into account the half-year and mid-quarter conventions. Use Table 4-A for 5-year property, Table 4-B for 7-year property, and Table 4-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 $429 and your basis in the refrigerator is $714. After figuring the 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 4-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 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 ($714) is more than 40% of the total basis of all property placed in service during the year ($1,143 × .40 = $457).
Because you placed the refrigerator in service in October, you use the fourth quarter column of Table 4-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 February, you use the first quarter column of Table 4-A and find that the depreciation percentage for year 1 is 35%. For that year, your depreciation deduction for the stove (after figuring the special depreciation allowance) is $105 ($300 × .35).
Table 4-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 4-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 3 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 2002 you choose to use ADS by entering the depreciation on line 20, Part III 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 and nonresidential real property.
Once you choose to use ADS, you cannot change your election.
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