Depreciation

Depreciation is a tax deduction that allows you to recover the cost or other basis of certain property over time. It is an annual allowance for the wear and tear, deterioration, or obsolescence of the property.

Generally speaking, all amounts paid to acquire, produce or improve tangible property that is not used up in the year must be capitalized and depreciated.

Recently, the IRS provided guidance that attempts to clarify the “tangible property” rules. However, this continues to be a complex area of taxation. There are many rules, definitions, de minimus safe harbors, and exceptions. You should consult your tax advisor to determine what costs are currently deductible and what should be capitalized and depreciated over time.

Depreciation begins when you place property in service for use in a trade or business or for the production of income. The property ceases to be depreciable when you have fully recovered the property’s cost or other basis or when you retire it from service, whichever happens first.

The Modified Accelerated Cost Recovery System (MACRS) is the proper depreciation method for most property placed in service in 2014.

For property used in your residential rental activity, you cannot make the election to expense new equipment in the year you purchase it, like other businesses can under Section 179 of the tax law.

Aside from the lack of availability of the Section 179 expensing election, all the usual rules for depreciation apply equally to rental real estate. If the real estate is used for residential purposes, such as an apartment building, rental house, mobile home, houseboat, etc., the buildings and any capital improvements on it must be depreciated over 27.5 years. If the property is used for other commercial purposes, it must be depreciated over 39 years. Land itself is never depreciable; only the buildings and improvements on the land can be written off.

Personal property components of the building may be depreciated over a shorter life than the building and improvements, in some cases in a few as 7 years. Personal property components include window air conditioners, carpeting, signage, and appliances, for example.

Cars are a listed property subject to special depreciation restrictions.

If you purchased property for personal use and then changed it to rental use, your depreciable basis will generally be the lesser of its adjusted basis, or its fair market value at the time of the conversion.

Depreciation is claimed on Form 4562, Depreciation and Amortization. Don't mix depreciation on rental property with any depreciation claimed on business assets; instead, file a separate Form 4562 for each activity you engage in.

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