Depreciation Expenses for Rental Property (building vs. land, fixed assets, improvements)

Let’s define what the term “depreciation” is and how it applies to rental property and other assets. This is a system of cost recovery for certain types of assets to account for wear and tear as well as obsolescence. This system has several classes and methods of depreciation based upon the type and use of the property. Also, it generally begins at the point of time in which the asset is placed into service for use.

Please note that when property is placed into service and disposed of in the same period, no depreciation is allowed.

In order to determine the proper method of depreciation, you must consider the following:

  • The class life and basis of the asset
  • If the property is “Listed Property” such as an automobile.
  • Taxpayer election to expense a portion of the asset under Sec. 179
  • Qualification of purchase bonus or other benefit in the first year of depreciation

We shall focus here on the most common method for most property which is called MACRS (Modified Accelerated Cost Recovery Method). Now let’s look at an example here, last year on June 15th you purchased a property in which there is the following attached:

  • Land $750,000 (stated value per County records)
  • Building $500,000 (per sale and property tax records)
  • Equipment $75,000 all new fixed assets purchased at point of sale by the new owner.

On September 1, you had some improvements made to the building by adding on window awnings. Total cost came to $7,500.

First let’s look at Land; due to its nature land is not depreciable so there is no cost to recover here. The next item is the Building at $500,000. This would be allowed and under the MACRS system based upon value the $500,000 would be assigned a cost recovery class life.

The Equipment that was purchased by the new owner would also qualify and would fall under the assigned MACRS schedule based upon its class life and cost basis.

The amount of depreciation that you can deduct may have certain “Dollar Limits”. Certain Real Property placed in service in 2012 should not exceed $500,000. If there is more than one property involved, you will need to allocate the limit between the properties up to the limit of $500,000. Also the purchase date and date placed into service sometimes are not the same. The completion of installation and the time the item started to be used is generally the date of service.

Lastly, the Building improvement, would also qualify, however there may be some other issues to consider in the basis since the window awnings may qualify for energy credits, etc. This of course would affect the first year basis depreciation cost calculation.

Always keep in mind certain incentives such as location in an “Enterprise Zone” will have an effect on your depreciation calculations since the basis may be adjusted by these credits. The Holding period will come into play at the time of sale or exchange.

For more information please review IRS Publications 946