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. Table 1 shows examples of many improvements.

   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.

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.

Interest expense.   You can deduct mortgage interest you pay on your rental property. Chapter 5 of Publication 535 explains mortgage interest in detail.

Expenses paid to obtain a mortgage.   Certain expenses you pay to obtain a mortgage on your rental property cannot be deducted as interest. These expenses, which include mortgage commissions, abstract fees, and recording fees, are capital expenses. However, you can amortize them over the life of the mortgage.

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 Schedule E (Form 1040), line 13. Attach a statement to your return showing the name and address of the other person. In the left margin of Schedule E, next to line 13, enter “See attached.”

Points.    The term “points” is often used to describe some of the charges paid by a borrower to take out a loan or a mortgage. These charges are also called loan origination fees, maximum loan charges, or premium charges. If any of these charges (points) are solely for the use of money, they are interest.

   Points paid when you take out a loan or mortgage result in original issue discount (OID). In general, the points (OID) are deductible as interest unless they must be capitalized. How you figure the amount of points (OID) you can deduct each year depends on whether or not your total OID, including the OID resulting from the points, is insignificant or de minimis. If the OID is not de minimis, you must use the constant-yield method to figure how much you can deduct.

De minimis OID.   The OID is de minimis if it is less than one-fourth of 1% (.0025) of the stated redemption price at maturity multiplied by the number of full years from the date of original issue to maturity (the term of the loan).

  If the OID is de minimis, you can choose one of the following ways to figure the amount you can deduct each year. You make this choice by deducting the OID in a manner consistent with the method chosen on your timely filed tax return for the tax year in which the loan is issued.

Constant-yield method.   If the OID is not de minimis, you must use the constant-yield method to figure how much you can deduct each year.

  You figure your deduction for the first year in the following manner.

  To figure your deduction in any subsequent year, you start with the adjusted issue price. To get the adjusted issue price, add to the issue price any OID previously deducted. Then follow steps (2) and (3) above.

  The yield to maturity (YTM) is generally shown in the literature you receive from your lender. If you do not have this information, consult your lender or tax advisor. In general, the YTM is the discount rate that, when used in computing the present value of all principal and interest payments, produces an amount equal to the principal amount of the loan.

  Qualified stated interest (QSI) is stated interest that is unconditionally payable in cash or property (other than another loan of the issuer) at least annually over the term of the loan at a single fixed rate.

  You figure the deduction for 2006 as follows.

Loan or mortgage ends.    If your loan or mortgage ends, you may be able to deduct any remaining points (OID) in the tax year in which the loan or mortgage ends. A loan or mortgage may end due to a refinancing, prepayment, foreclosure, or similar event. However, if the refinancing is with the same lender, the remaining points (OID) generally are not deductible in the year in which the refinancing occurs, but may be deductible over the term of the new mortgage or loan.

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. You cannot deduct the cost of traveling away from home if the primary purpose of the trip was the improvement of your property. You recover the cost of improvements by taking depreciation. For information on travel expenses, see chapter 1 of Publication 463.

  

To deduct travel expenses, you must keep records that follow the rules in chapter 5 of Publication 463.

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 2005, the standard mileage rate is 40½ cents a mile for all business miles driven before September 1. The rate is 48½ cents a mile for all business miles driven after August 31. For more information, see chapter 4 of Publication 463.

  

To deduct car expenses under either method, you must keep records that follow the rules in chapter 5 of Publication 463. 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 tax return preparation fees you paid to prepare Schedule E (Form 1040), Part I. For example, on your 2005 Schedule E you can deduct fees paid in 2005 to prepare Part I of your 2004 Schedule E. You can also deduct, as a rental expense, any expense (other than federal taxes and penalties) you paid to resolve a tax underpayment related to your rental activities.

If you own a condominium, you own a dwelling unit in a multi-unit building. You also own a share of the common elements of the structure, such as land, lobbies, elevators, and service areas. You and the other condominium owners may pay dues or assessments to a special corporation that is organized to take care of the common elements.

If you rent your condominium to others, you can deduct depreciation, repairs, upkeep, dues, interest and taxes, and assessments for the care of the common parts of the structure. You cannot deduct special assessments you pay to a condominium management corporation for improvements. But you may be able to recover your share of the cost of any improvement by taking depreciation.

If you have a cooperative apartment that you rent to others, you can usually deduct, as a rental expense, all the maintenance fees you pay to the cooperative housing corporation. However, you cannot deduct a payment earmarked for a capital asset or improvement, or otherwise charged to the corporation's capital account. For example, you cannot deduct a payment used to pave a community parking lot, install a new roof, or pay the principal of the corporation's mortgage. You must add the payment to the basis of your stock in the corporation.

Treat as a capital cost the amount you were assessed for capital items. This cannot be more than the amount by which your payments to the corporation exceeded your share of the corporation's mortgage interest and real estate taxes.

Your share of interest and taxes is the amount the corporation elected to allocate to you, if it reasonably reflects those expenses for your apartment. Otherwise, figure your share in the following way.

In addition to the maintenance fees paid to the cooperative housing corporation, you can deduct your direct payments for repairs, upkeep, and other rental expenses, including interest paid on a loan used to buy your stock in the corporation. The depreciation deduction allowed for cooperative apartments is discussed later.

Fair rental price.   A fair rental price for your property generally is the amount of rent 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.

  Ask yourself the following questions when comparing another property with yours. If any of the answers are no, the properties probably are not similar.

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

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. Do not count them as days of personal use if:

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

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:

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

Any day that you spend working substantially full time repairing and maintaining (not improving) 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.

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.

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 at a fair rental price.

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

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.

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 2005, continue to use the same method of figuring depreciation that you used in the past.

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 2005.

Excluded property.   You cannot use MACRS for certain personal property placed in service in your rental property in 2005 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 2005 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.

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:

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 2005 in your rental activities generally falls into one of the following classes. Also see Table 3.

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.

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.

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.

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.

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:

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

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

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.

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 Part III, column (f), 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 Part III, column (f), 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.

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.

See Conventions, later, for information on depreciation in the year you dispose of property.

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.)

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.

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: 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.

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.

Election.   For property placed in service during 2005 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.

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. See Form 8582 not required under Losses From Rental Real Estate Activities, later, to determine whether you have to complete Form 8582.

Rental activities in which you materially participated during the year are not passive activities, if for that year, you were a real estate professional. Losses from these activities are not limited by the passive activity rules.

For this purpose, each interest you have in a rental real estate activity is a separate activity, unless you choose to treat all interests in rental real estate activities as one activity.

If you were a real estate professional for 2005, complete line 43 of Schedule E (Form 1040).

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).

In January, Eileen Johnson bought a condominium apartment to live in. Instead of selling the house she had been living in, she decided to change it to rental property. Eileen selected a tenant and started renting the house on February 1. Eileen charges $750 a month for rent and collects it herself. Eileen received a $750 security deposit from her tenant. Because she plans to return it to her tenant at the end of the lease, she does not include it in her income. Her house expenses for the year are as follows:

Eileen must divide the real estate taxes, mortgage interest, and fire insurance between the personal use of the property and the rental use of the property. She can deduct eleven-twelfths of these expenses as rental expenses. She can include the balance of the allowable taxes and mortgage interest on Schedule A (Form 1040) if she itemizes. She cannot deduct the balance of the fire insurance because it is a personal expense.

Eileen bought this house in 1980 for $35,000. Her property tax was based on assessed values of $10,000 for the land and $25,000 for the house. Before changing it to rental property, Eileen added several improvements to the house. She figures her adjusted basis as follows:

On February 1, when Eileen changed her house to rental property, the property had a fair market value of $152,000. Of this amount, $35,000 was for the land and $117,000 was for the house.

Because Eileen's adjusted basis is less than the fair market value on the date of the change, Eileen uses $39,000 as her basis for depreciation.

Because the house is residential rental property, she must use the straight line method of depreciation using either the GDS recovery period or the ADS recovery period. She chooses the GDS recovery period of 27.5 years.

She uses Table 4-D to find her depreciation percentage. Because she placed the property in service in February, she finds the percentage to be 3.182%.

On April 1, Eileen bought a new dishwasher for the rental property at a cost of $425. The dishwasher is personal property used in a rental real estate activity, which has a 5-year recovery period. She uses the percentage under “Half-year convention” in Table 4-A to figure her MACRS depreciation deduction for the dishwasher.

On May 1, Eileen paid $4,000 to have a furnace installed in the house. The furnace is residential rental property. Because she placed the property in service in May, she finds the percentage from Table 4-D to be 2.273%.

Eileen figures her net rental income or loss for the house as follows:

Eileen uses Schedule E (Form 1040), Part I, to report her rental income and expenses. She enters her income, expenses, and depreciation for the house in the column for Property A. She uses Form 4562 to figure and report her depreciation. Eileen's Schedule E (Form 1040) is shown next. Her Form 4562 is not shown. See Publication 946 for information on how to prepare Form 4562.