FAQ 11 - Sale or Trade of Business, Depreciation, Rentals: Depreciation & Recapture

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Can the entire acquisition cost of a computer that I purchased for my business be deducted as a business expense or do I have to use depreciation?

The entire acquisition cost of a computer purchased for business use can be expensed under Code section 179 in the first year if qualified, or depreciated over a 5-year recovery period. Under section 179, you can elect to recover all or part of the cost of certain qualifying property, up to a dollar limit, by deducting it in the year you place the property in service. You can elect to expense the cost of qualifying property instead of recovering the cost by taking depreciation. To claim the expense in the first year, the property must be used more than 50% for business use, and meet the other requirements for expensing. One of those requirements is that the total cost of qualifying property you can deduct after you apply the dollar limit is limited to the taxable income from the active conduct of any trade or business during the year. Any cost not deductible in one year under section 179 because of the business income limit can be carried to the next year.

For any taxable year beginning after 2002 and before 2006, a new law raised the aggregate cost that can be expensed under section 179 to $100,000 and also expanded the definition of Code section 179 property to include off-the-shelf computer software. See IRS site for Code Section 179 for the expanded definition.

If you make a choice to depreciate the property you can claim in the placed-in service year of the property a special depreciation allowance for eligible property you acquired after September 10, 2001 and before January 1, 2005. The special depreciation is figured before you calculate your regular depreciation. To qualify for the special depreciation the property must:

Be property that is depreciated generally under MACRS (Modified Accelerated Cost Recovery System) and that has a recovery period of 20 years or less. Property required to be depreciated under the straight-line method of the alternative depreciation system of MACRS generally is not eligible.
Be property that is acquired by you after September 10, 2001 and before January 1, 2005.
Be property that is placed in service by you before January 1, 2005.
Be property the original use of which began with you after September 10, 2001. This means that the property is new property.

For eligible property acquired after September 10, 2001, and before May 6, 2003, the special depreciation deduction is equal to 30% of the property's depreciable basis. For eligible property acquired after May 5, 2003 and before January 1, 2005, the special depreciation deduction is equal to 50% of the property's depreciable basis. If the property is acquired after May 5, 2003, but there was a written binding contract to acquire the property in effect before May 6, 2003, the property is not eligible for the 50% special depreciation. Also, if the property is acquired after May 5, 2003, but the original use of the property began before May 6, 2003, the property is not eligible for the 50% special depreciation. And, if you acquired the property before May 6, 2003, but placed the property in service after May 5, 2003, the property is not eligible for the 50% special depreciation.

If the property is eligible for the 50% special depreciation deduction and you claim this 50% depreciation, you cannot claim the 30% special depreciation deduction for the property. However, you can elect to deduct the 30% (instead of 50%) special depreciation for property eligible for the 50% special depreciation deduction. These elections are made for an entire class of property (for example, 5-year property) instead of for each property.

If your property is located within the New York Liberty Zone, there are different rules for special depreciation deduction.

See Publication 946, How to Depreciate Property for additional information on the special deduction.

What kinds of property can be depreciated for tax purposes?

Only property used in a trade or business or in an income producing activity can be depreciated. Additionally, the property must be something that wears out or becomes obsolete and it must have a determinable useful life substantially beyond the tax year. The kinds of property that can be depreciated include, but are not limited to, machinery, equipment, buildings, vehicles, and furniture. Some intangible property may also be depreciable (e.g. patents). Depreciation is a complex topic. For more information, refer to Tax Topic 704, Depreciation, or Publication 946, How to Depreciate Property , or Publication 534 (PDF) , Depreciating Property Placed in Service Before 1987.

I purchased a computer last year to do online day trading part-time from home for additional income. Can I deduct or depreciate the cost of the computer or internet connection from my investment income?

You may deduct investment expenses (other than interest expenses) as miscellaneous itemized deductions on Form 1040, Schedule A (PDF), line 22, Itemized Deductions. This would include depreciation on the portion of your computer used for investment purposes, and the portion of your internet access charges used for investment purposes.

The entire acquisition cost of a computer purchased for business use can be expensed under Code section 179 in the first year if qualified, or depreciated over a 5-year recovery period. Under section 179, you can elect to recover all or part of the cost of certain qualifying property, up to a dollar limit, by deducting it in the year you place the property in service. You can elect to expense the cost of qualifying property instead of recovering the cost by taking depreciation. To claim the expense in the first year, the property must be used more than 50% for business use (as opposed to investment use), and meet the other requirements for expensing. One of those requirements is that the total cost of qualifying property you can deduct after you apply the dollar limit is limited to the taxable income from the active conduct of any trade or business during the year. Any cost not deductible in one year under section 179 because of the business income limit can be carried to the next year.

The 2003 Jobs and Growth Act raised the aggregate cost that can be expensed for any tax year beginning after 2002 and before 2006 to $100,000. The new law also expanded the definition of Code Section 179 property to include off-the-shelf computer software. See Code Section 179 for the expanded definition. If the business use falls to 50% or less in a later year, these tax benefits may be subject to recapture. See Publication 946 , How to Depreciate Property for additional information on the section 179 deduction.

Because these deductions are for investment expenses rather than for business expenses, these deductions must be reduced by 2% of your adjusted gross income. Use Form 4562 (PDF), Depreciation and Amortization, to compute the depreciation for the portion of your computer used for investment purposes.

Note: Unless the computer is used more than 50% for business purpose (as opposed to investment purposes), you cannot claim section 179 expensing of the computer or claim accelerated depreciation (including the special depreciation) for it. For more information, refer to "Listed Property" in Publication 946, How to Depreciate Property.

What form and line do I deduct the standard mileage rate for my business travel and do I need to figure depreciation of the vehicle, too?

A Sole Proprietor's business use of a car or truck is claimed on line 9 of Form 1040, Schedule C (PDF), Schedule C, Profit or Loss from Business or, if eligible, line 2 of Form 1040, Schedule C-EZ (PDF), Net Profit from Business. You may use either the actual expense method in calculating your car or truck expense or, if eligible, the standard mileage rate. Depreciation expense is already included in this standard mileage rate. Depreciation is only calculated as a separate expense when using the actual expense method. Deductible employee business use of a car or truck may be taken on Form 2106 (PDF), Employee Business Expenses , or if, eligible, line 1 of Form 2106-EZ (PDF), Unreimbursed Employee Business Expenses. The car and truck expenses are then taken with other employee business expenses on line 20, Form 1040, Schedule A&B (PDF) Itemized Deductions . For more information, refer to Publication 463, Travel, Entertainment, Gift, and Car Expenses , and Publication 535, Business Expenses .

I have a home office. Can I deduct expenses like mortgage, utilities, etc., but not deduct depreciation so that when I sell this house, the basis won't be affected?

If you qualify to deduct expenses for the business use of your home, you can claim depreciation for the part of your home that is a home office. Generally, the part of your home that is a home office is depreciated over a recovery period of 39 years using the straight line method of depreciation and a mid-month convention. If you do not claim depreciation on that part of your home that is a home office, you are still required to reduce the basis of your home for the allowable depreciation of that part of your home that is a home office when reporting the sale of your home. For more information, refer to Publication 587, Business Use of Your Home.

We have incurred substantial repairs to our rental property: new roof, gutters, windows, furnace, and outside paint. What are the IRS rules concerning depreciation?

Replacements of roof, rain gutters, windows, and furnace on a residential rental property are capital improvements to the structure because they materially add to the value of your property or substantially prolong its life. The items would be in the same class of property as the rental property to which they are attached. Since the property is residential rental property, the items are generally depreciated over a recovery period of 27.5 years using the straight line method of depreciation and a mid-month convention.

Repairs, such as repainting the residential rental property, are currently deductible expenses. 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. In that case, you should capitalize and depreciate the repair costs as the same class of property that you have restored or remodeled as discussed above. For more information, refer to Publication 527, Residential Rental Property, and Publication 946, How to Depreciate Property.

I purchased a rental property last year. What closing costs can I deduct?

The only deductible closing costs are those for interest, and deductible real estate taxes. Other settlement fees and closing costs for buying the property become additions to your basis in the property. These basis adjustments 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.
Fees related to obtaining a loan are capital expenses and should be amortized over the life of the loan.

For additional information, refer to Publication 527, Residential Rental Property, Publication 17, Your Individual Income Tax Guide, and Publication 535, Business Expenses.

Can you deduct Private Mortgage Insurance (PMI) premiums on rental property? If so, which line item on Schedule E?

Yes. You can deduct Private Mortgage Insurance premium on line 9 of Form 1040, Schedule E (PDF), Supplemental Income and Loss. Write "PMI" on the dotted line.

I rent my home out for two weeks each year. Do I have to show the income on my return?

You must first consider if you use your dwelling as a home. You are considered to use a dwelling as a home if you use it for personal purposes during the tax year for more than the greater of 14 days or 10% of the total days it is rented to others at a fair rental price. It is possible that you will use more than one dwelling unit as a home during the year. For example, if you live in your main home for 11 months and in your vacation home for 30 days, your home is a dwelling unit and your vacation home is also a dwelling unit, unless you rent your vacation home to others at a fair rental value for more than 300 days during the year.

There is a special rule if you use a dwelling as a home and rent it for fewer than 15 days. In this case, do not report any of the rental income and do not deduct any expenses as rental expenses. If you itemize your deduction on Form 1040, Schedule A (PDF), Itemized Deductions , you may be able to deduct mortgage interest, property taxes, and any casualty losses. For additional information, refer to Tax Topic 415, Renting Vacation Property/Renting to Relatives and Publication 527 , Residential Rental Property (including Rental of Vacation Homes) .

I am renting a house to my son and daughter-in-law. Can I claim rental expenses?

In general, if you receive income from the rental of a dwelling unit, such as a house, apartment, or duplex, there are certain expenses you may deduct.

Besides knowing which expenses may be deductible, it is important to understand potential limitations on the amounts of rental expenses that may be deducted in a tax year.

There are several types of limitations that may apply.

Passive Activity losses : In general, you can deduct passive activity losses only from passive activity income (a limit on loss deductions). You carry any excess loss forward to the following year or years until used, or until deducted in the year you dispose of your entire interest in the activity in a fully taxable transaction. There are several exceptions that may apply to the passive activity limitations. Refer to Publication 527 , Residential Rental Property and Publication 925 , Passive Activity and At-Risk Rules .
At risk rules: The at-risk rules limit your losses from most activities to your amount at risk in the activity. You treat any loss that is disallowed because of the at-risk limits as a deduction from the same activity in the next tax year. If your losses from an at-risk activity are allowed, they are subject to recapture in later years if your amount at risk is reduced below zero. Refer to Publication 925 , Passive Activity and At-Risk Rules.

Not for profit activities: 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. Any rental expenses in excess of rental income cannot be carried forward to the next year. Refer to Publication 527 , Residential Rental Property and Publication 535 , Business Expenses .

Rental of a dwelling unit: The tax treatment of rental income and expenses for a dwelling unit that you also use for personal purposes (renting to a relative may be considered personal use even if they are paying you rent) depends on whether you use it as a home. Refer to Publication 527 , Residential Rental Property .

Expenses in connection with rental of a dwelling unit for less than 15 days per year . Refer to Publication 527 , Residential Rental Property .

What form(s) do we need to fill out to report the sale of rental property?

The gain or loss on the sale of rental property is reported on Form 4797 (PDF), Sale of Business Property. Form 1040, Schedule D (PDF), Capital Gains and Losses, is often used in conjunction with Form 4797. For further information, refer to Publication 544, Sales on Other Disposition of Assets,Publication 550, Investment Income and Expense, the Instructions to Form 4797 (PDF), Sale of Business Property, and the Instructions to Form 1040, Schedule D, Capital Gain and Losses.

We are selling rental property and have never claimed depreciation. What do we do about this when we file our taxes?

When reporting the sale of or computing gain or loss on rental property, you are required to make an adjustment to your basis for allowable depreciation regardless of whether the deduction was taken. For more information refer to Publication 544, Sales or Other Dispositions of Assets, and the Form 4797 Instructions, Sales of Business Property.

You can claim the depreciation not taken for the rental property in the years before the year of sale. How to do this depends on when you placed in service the rental property. If you placed in service the rental property before calendar year 2003, you may amend your income tax returns for the years before the year of the sale by using Form 1040X (PDF), Amended U.S. Individual Income Tax Return, to take the depreciation deductions for the rental property that should have been taken. Or, you may file a Form 3115 (PDF), Application for Change in Accounting Method, to claim the depreciation for the rental property that should have been taken for the years before the year of the sale. The Form 3115 must be timely filed for the same tax year in which you sell the rental property.

If you placed in service the rental property after calendar year 2002 and you have unclaimed depreciation for two or more years before the year of sale, you must use Form 3115 (PDF), Application for Change in Accounting Method, to claim the depreciation for the rental property that should have been taken for the years before the year of the sale. The Form 3115 must be timely filed for the same tax year in which you sell the rental property.

If you placed in service the rental property after calendar year 2002 and you have unclaimed depreciation for only the year immediately preceding the year of sale, you may amend your income tax return for that prior year by using Form 1040X (PDF), Amended U.S. Individual Income Tax Return, to take the depreciation deduction for the rental property that should have been taken. Or, you may file a Form 3115 (PDF), Application for Change in Accounting Method, to claim the depreciation for the rental property that should have been taken for the prior year. The Form 3115 must be timely filed for the same tax year in which you sell the rental property.

What forms do we file to report a loss on the sale of a rental property?

The loss on the sale of rental property is reported on Form 4797 (PDF), (Sale of Business Property) as ordinary loss.

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