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Chapter 10. Rental Income and Expenses Introduction This chapter discusses rental income and expenses. It covers the following topics: ∙ Rental Income ∙ Rental Expenses ∙ Vacation Homes and Other Dwelling Units ∙ Depreciation ∙ Limits on Rental Losses ∙ How to Report Your Rental Income and Expenses If you sell or otherwise dispose of your rental property, see Publication 527, Residential Rental Property. If you have a loss from damage to, or from theft of, rental property, see Publication 334, Tax Guide for Small Business. If you rent out a condominium or a cooperative apartment, some special rules apply to you even though you receive the same tax treatment as other owners of rental property. See Publication 527 for more information. Related publications and forms. This chapter refers to several publications and forms that you may need. The list of forms does not include Forms 1040, 1040A, and 1040EZ. For more information, you may want to order the following: Publication 334, Tax Guide for Small Business Publication 527, Residential Rental Property Publication 534, Depreciation Publication 535, Business Expenses Publication 544, Sales and Other Dispositions of Assets Publication 587, Business Use of Your Home Publication 909, Alternative Minimum Tax for Individuals Publication 925, Passive Activity and At-Risk Rules Publication 946, How To Begin Depreciating Your Property Form 4562, Depreciation and Amortization Form 8582, Passive Activity Loss Limitations Schedule E (Form 1040), Supplemental Income and Loss Rental Income Rental income is any payment you receive for the use or occupation of property. You generally must include in your gross income all amounts you receive as rent. In addition to amounts you receive as normal rent payments, there are other amounts that may be rental income. Advance rent. Advance rent is any amount you receive before the period that it covers. Include advance rent in your rental income in the year you receive it regardless of the period covered or the method of accounting you use. Deduct rental expenses when you pay or incur them. Example. You sign a 10─year lease to rent your property. In the first year, you receive $5,000 as rent for the first year and $5,000 in advance as rent for the last year of the lease. You must include $10,000 in your income in the first year. Security deposits. Do not include a security deposit in your income when you receive it if you plan to return it to your tenant at the end of the lease. But, if during any year, you keep part or all of the security deposit because your tenant does not live up to the terms of the lease, include the amount you keep in your income for that year. If an amount called a security deposit is to be used as a final payment of rent, it is advance rent. Include it in your income when you receive it. Payment for canceling a lease. If your tenant pays you to cancel a lease, the amount you receive is rent. Include the payment in your income for the year you receive it whether you use the cash or accrual method of accounting. Expenses paid by tenant. If your tenant pays any of your expenses, these payments are rental income. You must include them in your income. You can deduct those expenses if they are otherwise deductible. Property or services. If you receive property or services, instead of money, as rent, include the fair market value of the property or services in your rental income. If the services are provided at an agreed upon or specified price, that price will be the fair market value in the absence of evidence to the contrary. Rental of property also used as a home. If you rent property that you also use as your home and you rent it for less than 15 days during the tax year, do not include the rent you receive in your gross income. You cannot deduct expenses other than allowable interest, taxes, and casualty and theft losses. See Vacation Homes and Other Dwelling Units, later. If you own a part interest in rental property, you must report your part of the rental income from the property. Rental Expenses This part discusses repairs and certain other expenses of renting property that you ordinarily can deduct from your gross rental income. It includes information on the expenses you can deduct if you rent part of your property, or if you change your property to rental use. Depreciation, which you can also deduct from your gross rental income, is discussed later. If you own a part interest in rental property, you can deduct your part of the expenses that you paid. When to deduct. You generally deduct your rental expenses in the year you pay or incur them. Pre-rental expenses. You can deduct your ordinary and necessary expenses for managing, conserving, or maintaining rental property from the time you make it available for rent. See Vacant rental property, below. Expenses for rental property sold. If you sell property you held for rental purposes, you can deduct the ordinary and necessary expenses for managing, conserving, or maintaining the property until it is sold. Vacant rental property. If you hold property for rental purposes, you may be able to deduct your ordinary and necessary expenses for managing, conserving, or maintaining the property while the property is vacant. However, you cannot deduct any loss of rental income for the period the property is vacant. Repairs and Improvements You can deduct the cost of repairs that you make to your rental property. You cannot deduct the cost of improvements. You recover the costs of improvements by taking depreciation (explained later). Separate the costs of repairs and improvements, and keep accurate records showing the cost of improvements. You will need to know these costs when you sell or depreciate your property. 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 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 your property, prolongs its useful life, or adapts it to new uses. Putting a recreation room in an unfinished basement, paneling a den, adding a bathroom or bedroom, putting decorative grillwork on a balcony, putting up a fence, putting in new plumbing or wiring, putting in new cabinets, putting on a new roof, and paving a driveway are examples of improvements. If you make improvements to property before you begin renting it, add the cost of the improvement to the basis of the property. Basis is explained later under Modified Accelerated Cost Recovery System (MACRS). Other Expenses You can deduct from your gross rental income expenses for advertising, janitor and maid service, utilities, fire and liability insurance, taxes, interest, commissions for the collection of rent, ordinary and necessary travel and transportation, and other expenses discussed below. Salaries and wages. You can deduct reasonable salaries and wages you pay to your employees. You can also deduct bonuses you pay to your employees if, when added to their regular salaries or wages, the total is not more than reasonable pay. You can deduct reasonable wages you pay to your dependent child if your child is your bona fide employee. However, you cannot deduct the cost of meals and lodging for the child. 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. See Depreciation, later. Insurance premiums. You can deduct insurance premiums you pay. If you pay the premiums 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 continue to deduct your premium in this manner for as long as the insurance is in effect. You cannot deduct the total premium in the year you pay it. Local benefits. Generally, you cannot deduct charges for local benefits that increase the value of your property, such as for putting in streets, sidewalks, or for water and sewer systems. 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. Charges for services. You can deduct charges you pay for providing services for your rental property, such as water, sewer, and trash collection. Travel and transportation expenses. You can deduct your ordinary and necessary travel expenses when you are traveling away from home, as well as your ordinary and necessary transportation expenses when you are not traveling away from home, if the expenses are in connection with the management, conservation, or maintenance of property held by you for rental purposes. Generally, if you used your car in such transportation in 1992, you can claim either the standard mileage rate of 28 cents per mile for each mile of rental activity use, or your actual expenses for such use. See Limits on Deductions for Rental Expenses, later. For additional information, see Publication 527. Renting Part of Your Property If you rent part of your property, you must divide certain expenses between the part of the property used for rental purposes and the part of the property used for personal purposes as though you actually had two separate pieces of property. You can deduct a part of some expenses, such as mortgage interest and property taxes, as a rental expense. You can deduct the other part, subject to certain limitations, only if you itemize your deductions. You can also deduct as a rental expense a part of other expenses that normally are nondeductible personal expenses, such as expenses for electricity, a second telephone line, or painting the outside of your house. You do not have to divide the expenses that relate only to the rental part of your property. If you paint a room that you rent, or if you pay premiums for liability insurance in connection with renting a room in your home, your entire cost is a rental expense. You can deduct depreciation, discussed later, on the part of the property used for rental purposes as well as on the furniture and equipment you use for these purposes. How to Divide Expenses If an expense is for both rental use and personal use, such as mortgage interest or the cost of heat for the entire house, you must divide the expense between the rental use and the personal use. You can use any reasonable method for dividing the expenses. The two most common methods are based on the: Number of rooms in your home, and area of your home. Allocating costs based on the number of people involved may be the proper method to use to divide certain expenses. For example, if you provide board along with rooms you rent to tenants, the most accurate method of dividing food costs between rental and personal expenses may be one based on the total number of people eating the food. Or, if you rent an apartment and your tenants have unrestricted use of your second telephone line, the number of people using it may be the best method for dividing the monthly charge for the telephone. Exception. If you rent part of your main or second home to no more than two tenants for residential purposes, and that part is not a self-contained residential unit, no allocation of mortgage interest is required. You may treat that part as used by you for residential purposes. Limits on Deductions for Rental Expenses If you rent out part of your property and you also use that or another part of the same property for personal purposes during the year, your deductions for rental expenses for the property may be limited as discussed later, under Vacation Homes and Other Dwelling Units. Business use of home. If you use part of your home for business (including work as an employee), your deductions for business use of your home are limited. See Publication 587, Business Use of Your Home. Property Changed to Rental Use If you change your home, apartment, or other property, or a part of it, to rental use at any time other than at the beginning of your tax year, you must divide yearly expenses such as depreciation, taxes, and insurance between rental use and personal use. You can deduct as rental expenses only the part of the expense that is for the part of the year the property was used or held for rental purposes. You cannot deduct depreciation or insurance for any property or part of property held for personal use. However, you can deduct the allowable part of the interest and tax expenses for personal use as an itemized deduction on Schedule A (Form 1040). If you change your property, or a part of it, to rental property, special rules apply for figuring your basis for depreciation. See Property Changed to Business or Rental Use in Chapter 14. Example. You moved from your home in May 1992 and started renting it out on June 1, 1992. You can deduct as rental expenses seven-twelfths of your yearly expenses such as taxes and insurance. You can deduct as rental expenses, starting with June, the amounts you pay for items generally billed monthly, such as utilities. See Personal home changed to rental use, later, under Modified Accelerated Cost Recovery System (MACRS) for information about how to figure your deduction for depreciation. Other limits. If you change property to rental use and later use part or all of it for personal purposes, there are other rules that apply to how much of your rental expenses you can deduct. These rules are explained next under Vacation Homes and Other Dwelling Units. Vacation Homes and Other Dwelling Units If you rent out part or all of a vacation home or other dwelling unit and you also use any part of the dwelling unit for personal purposes during the year, you must divide your expenses between the rental use and the personal use. Depending on how your property was used, you may not be able to deduct any of your rental expenses, you may not be able to deduct all of your rental expenses in the year that you pay them, or you may not have to include any of the rent in your income. Dwelling Unit For purposes of the rules that apply to vacation homes and other dwelling units, a dwelling unit includes a house, apartment, condominium, mobile home, boat, or similar property. It does not include property used exclusively as a hotel, motel, inn, or similar establishment. Property is used exclusively as a hotel, motel, inn, or similar establishment if it is regularly available for occupancy by paying customers and is not used by an owner as a home during the year. Used as Home You use a dwelling unit as a home during the tax year if you use it for personal purposes for more than 14 days and more than 10% of the number of days during the year that it is rented at a fair rental price. See Personal Use, later, for information on how to determine days of personal use. To determine whether you use a dwelling unit as a home, do not count any day on which you use it for personal purposes as a day on which it is rented at a fair rental price. Fair rental price. A fair rental price for your property generally is an amount 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. Is it used for the same purpose? Is it approximately the same size? Is it in approximately the same condition? Does it have similar furnishings? Is it in a similar location? If any of the answers are no, the properties probably are not similar. Examples. The following examples show how to determine whether your rental property is a dwelling unit or a hotel, motel, inn, or similar property. Example 1. You converted the basement of your home into an apartment with a bedroom, a bathroom, and a small kitchen. You rent the apartment to college students during the regular school year. You rent to them on a 9-month (273 days) lease. During the summer, your brothers stay with you for a month (30 days) and live in the apartment rent free. Your basement apartment is a dwelling unit (and not a hotel, motel, inn, or similar establishment) because you use it as a home (that is, for personal purposes for more than 14 days and more than 10% of the number of days for which it is rented). Example 2. You rent out the guest bedroom in your home during the local college's homecoming, commencement, and football weekends (a total of 27 days). Your sister-in-law stays in the room, rent free, for the last three weeks (21 days) in July. The room itself is not a dwelling unit, but it is part of a dwelling unit. The room is not used exclusively as a hotel, motel, inn, or similar establishment because you use it as a home (that is, for personal purposes for more than 14 days and more than 10% of the number of days for which it is rented). Example 3. You rent out a room in your home that is always available for occupancy by paying customers. You do not use the room yourself, and you do not allow anyone other than paying customers to use the room. The room is used exclusively as a hotel, motel, inn, or similar establishment and is therefore not a dwelling unit. Example 4. You own a cottage at the shore. You rent it out from June 1 through August 31, a total of 92 days. During 1992, the tenant who rented the cottage for the month of July was unable to use it from July 4 through July 8. The tenant allowed you to use the cottage for those 5 days. The tenant did not ask for a refund of or a reduction in the rent. Your family used the cottage for 3 of those days. For purposes of determining whether you used the cottage as a home during 1992, you do not count those 3 days as days on which the cottage was rented at a fair rental price. The cottage was rented at a fair rental price for 89 days (92 - 3 = 89). You use the cottage as a home if you use it for personal purposes for more than 14 days. Personal Use You use a dwelling unit for personal purposes on any day that it is used by any one of the following. 1) You or by any other person who has an interest in it, unless it is rented as a main home under a shared equity financing agreement (defined below). 2) A member of your family or by a member of the family of any other person who has an interest in it, unless the family member uses the dwelling unit as his or her main home and pays a fair rental price. (Family includes only brothers and sisters, half-brothers and half-sisters, spouses, ancestors (parents, grandparents, etc.) and lineal descendants (children, grandchildren, etc.)) 3) Anyone under an arrangement that lets you use some other dwelling unit. 4) Anyone at less than a fair rental price. Main home. If you have more than one home, your main home is the one you live in most of the time. Rental to person with interest in unit. You use a dwelling unit for personal purposes if you rent it to someone who has an interest in it unless the rental is under a shared equity financing agreement. 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. Rental to family member. You do not use a dwelling unit for personal purposes if you rent it at a fair rental price to a member of your family who uses it as his or her main home (unless he or she has an interest in the unit). Donation of use of property. You use a dwelling unit for personal purposes if: You donate the use of the unit to a charitable organization, The organization sells the use of the unit at a fund-raising event, and The purchaser uses the unit. Examples The following examples show how to determine days of personal use. Example 1. You and your neighbor are co-owners of a condominium at the beach. You rent the unit out to vacationers whenever possible. The unit is not used as a main home by anyone. Your neighbor uses the unit for two weeks every year. Because your neighbor has an interest in the unit, both of you are considered to have used the unit for personal purposes during those two weeks. Example 2. You and your neighbors are co-owners of a house under a shared equity financing agreement. Your neighbors live in the house and pay you a fair rental price. Even though your neighbors have an interest in the house, the days your neighbors live there are not counted as days of personal use by you. This is because your neighbors rent the house as their main home under a shared equity financing agreement. Example 3. You own a rental property that you rent to your son. Your son has no interest in this dwelling unit. He uses it as his main home. He pays you a fair rental price for the property. Your son's use of the property is not personal use by you because your son is using it as his main home, he has no interest in the property, and he is paying you a fair rental price. Example 4. You rent your beach house to Mary Smith. Mary rents her house in the mountains to you. You each pay a fair rental price. You are using your house for personal purposes on the days that Mary uses it because your house is used by Mary under an arrangement that allows you to use her house. Example 5. You rent an apartment to your mother at less than a fair rental price. You are using the apartment for personal purposes on the days that your mother rents it. Days Not Counted as Personal Use Some days you spend at the dwelling unit are not counted as days of personal use. Repairs and maintenance. Any day that you spend repairing and maintaining your property on a full-time basis is not counted as a day of personal use. Do not count such a day as a day of personal use even if people related to you use the property for recreational purposes on the same day. Use as home before or after renting. You do not have to count days on which you used the property as your main home as days of personal use if you used the property as your main home either before or after renting it or offering it for rent, and either: 1) You rented or tried to rent the property for 12 or more consecutive months, or 2) You rented or tried to rent the property for a period of less than 12 consecutive months and the period ended because you sold or exchanged the property. See Publication 527, Residential Rental Property, for more information about this situation. Division of Expenses If you use a dwelling unit for both rental and personal purposes, you must divide your expenses between the rental use and the personal use. For purposes of dividing your expenses: 1) Any day that the unit is rented at a fair rental price is a day of rental use even if you have personally used the unit for that day, and 2) A unit is not considered used for rental during the time that it is held out for rent but not actually rented. Example. You offer your beach cottage for rent from June 1 through August 31 (92 days). Your family uses the cottage during the last 2 weeks in May (14 days). During 1992, you were unable to find a renter for the first week in August (7 days). The person who rented the cottage for July allowed you to use it over a weekend (2 days) without any reduction in or refund of rent. The cottage was not used at all before May 17 or after August 31. The cottage was used for rental a total of 85 days (92 - 7 = 85). The days it was held out for rent but not rented (7 days) are not days of rental use. For purposes of dividing expenses, the July weekend on which you used it (2 days) is rental use because you received a fair rental price for the weekend. You used the cottage for personal purposes for 14 days (the last 2 weeks in May). Figuring Your Income and Deductions How you figure your rental income and deductions depends on how many days of use of the property were personal and how many days were rental. General Rule If you do not use a dwelling unit as a home, you divide your expenses between personal use and rental use based on the number of days it was used for each purpose. Your deductible rental expenses can be more than your gross rental income. However, see Passive Activity Limits, later. Property Used as a Home If you use a dwelling unit as a home (as explained earlier), how you figure your rental income and deductions depends on how many days the unit was rented. Rented less than 15 days. If you use a dwelling unit as a home and you rent it for less than 15 days during the year, you do not report any of the rental income. However, you cannot deduct any expenses as rental expenses. You can deduct your allowable interest, taxes, and casualty and theft losses on Schedule A (Form 1040) if you itemize deductions. Rented 15 days or more. If you use a dwelling unit as a home and rent it for 15 days or more during the year, you report all your rental income. You must divide your expenses between the personal use and the rental use based on the number of days used for each purpose. If you had a net profit from the rental property for the year (that is, if your rental income is more than the total of your rental expenses, including depreciation), deduct all of your rental expenses. However, if you did not have a net profit from the rental property, you may not be able to deduct all of your rental expenses. Note. If you had a casualty loss on the rental property during the year, see Publication 527 for information about how to figure your net rental loss. If you cannot deduct all of your home mortgage interest because of the limit on the deduction of home mortgage interest, see Publication 527. The limit on the deduction of home mortgage interest is explained in Chapter 24, under Home Mortgage Interest. Figuring your loss. If you: Did not have a net profit for the year from the rental property, Did not have a casualty loss on the rental property during the year, and Can deduct all of your mortgage interest paid during the year, deduct your rental expenses for the year in the following order. 1) Deduct the rental use portion of mortgage interest and taxes. 2) Deduct rental expenses that are not directly related to the dwelling unit itself. This includes expenses such as rental agent fees, office supplies, depreciation on office equipment used exclusively in the business of renting property, and advertising fees. 3) Deduct the rental use portion of any expenses not described in (1) or (2) (other than depreciation and other basis adjustments). This includes expenses such as repairs, insurance, and utilities. You can deduct these expenses only if your gross rental income is more than the total of the expenses described in (1) and (2). If these expenses are more than your gross rental income reduced by the expenses described in (1) and (2), deduct only the amount that is equal to your gross rental income reduced by those expenses. See Carryover of expenses, below. 4) Deduct the rental use portion of depreciation and other basis adjustments to that rental property. You can deduct depreciation and other basis adjustments only if your gross rental income is more than the total of the deductions in (1), (2), and (3). If your depreciation and other basis adjustments are more than your gross rental income reduced by the total of the expenses in (1), (2), and (3), deduct only the amount that is equal to your gross rental income reduced by those expenses. See Carryover of expenses, below. Where to report. Report your rental income and all your deductible expenses for the rental use on Schedule E (Form 1040), Supplemental Income and Loss. You can deduct allowable interest, taxes, and casualty losses for the personal use of the property on Schedule A (Form 1040) if you itemize deductions. Carryover of expenses. If the total of your rental expenses is more than your gross rental income, the expenses that you are not allowed to deduct may be carried forward to the next year and treated as rental expenses for the same property. Any expenses carried forward to next year will be subject to any applicable limits next year. You can deduct the expenses carried over to a year only up to the amount of your rental income for that year, even if you do not use the property as your home for that year. Not Rented For Profit If you do not expect to make a profit from the rental of a dwelling unit, you can deduct your rental expenses only up to the amount of your rental income. You must deduct your expenses using the rules explained in Publication 535, Business Expenses. You cannot carry forward any of your rental expenses that are more than your rental income. Where to report. You report your rental income on line 22, Form 1040. You claim your deductible rental expenses as a miscellaneous deduction on line 20, Schedule A (Form 1040) if you itemize deductions. You can deduct most miscellaneous deductions, including these, only to the extent the total is more than 2% of your adjusted gross income. For more information about miscellaneous deductions, see Chapter 30. Depreciation Depreciation is the annual deduction you take to recover the cost of rental property that is used for more than one year. Several factors determine how much depreciation you can deduct. The main factors are: (1) your basis in the property, and (2) the recovery period for the property. You can deduct depreciation only on the part of your property used for rental purposes. Depreciation reduces your basis for figuring gain or loss on a later sale or exchange. You may have to use Form 4562, Depreciation and Amortization, to report your depreciation. See the instructions for the form. You should claim the correct amount of depreciation each tax year. If you did not deduct depreciation in earlier years, you cannot deduct the unclaimed depreciation in the current or any later tax year. However, you can claim the depreciation on an amended return (Form 1040X) for the earlier year. See Amended Returns and Claims for Refund in Chapter 1 for more information. Methods of depreciation. There are three systems involved in the computation of depreciation. The depreciation system that applies to a particular piece of property is determined by the type of property and when the property was placed in service. For tangible property, you use: 1) MACRS (or alternate MACRS) if placed in service after 1986, 2) ACRS if placed in service after 1980 but before 1987, or 3) Straight line or an accelerated method of depreciation, such as the declining balance method, if placed in service before 1981. This chapter discusses MACRS only. If you placed property in service during 1992, see Publication 946, How To Begin Depreciating Your Property, for additional information about MACRS. If you need information about any other method of depreciation, see Publication 534, Depreciation. Tangible property. Tangible property is any property that you can see and touch. This includes automobiles, buildings, and equipment. Section 179 election. The election to expense certain depreciable business assets is not available for property held merely for the production of income, such as rental property. Cannot be more than basis. The total of all your yearly depreciation deductions cannot be more than your cost or other basis of the property. For this purpose, the total depreciation must include any depreciation that you were allowed to claim, even if you did not claim it. Cooperative apartments. If you are a tenant-stockholder in a cooperative housing corporation and you rent your cooperative apartment to others, you may deduct your share of the corporation's depreciation. See Publication 527, Residential Rental Property, for information on how to figure your depreciation deduction. Modified Accelerated Cost Recovery System (MACRS) The modified accelerated cost recovery system (MACRS) applies to all tangible property placed in service during 1992. If you placed your property in service before 1992, continue to use the same method of figuring depreciation that you used in the past. Personal home changed to rental use. Use MACRS to figure the depreciation on property you used as your home and changed to rental property in 1992. Property Classes Under MACRS Each item of property that can be depreciated is assigned to a property class. The recovery period of a piece of property depends on the class the property is in. The property classes are: 3─year property, 5─year property, 7─year property, 10─year property, 15─year property, 20─year property, Nonresidential real property, and Residential rental property. The class to which property is assigned is determined by its class life. Class life is discussed in Publication 534. Optional tables. There are optional percentage tables that you can use to figure your depreciation under MACRS. See Optional Tables, later. Recovery Periods Under MACRS, tangible property usually used in rental activities that you placed in service during 1992 falls into one of the following classes. The other recovery classes are discussed in Publication 534. 1) 5─year property. This class includes property with a class life of more than 4 years but less than 10 years, such as computers and peripheral equipment, office machinery (typewriters, calculators, copiers, etc.), automobiles, and light trucks. Note. Depreciation on automobiles, computers, and cellular telephones is limited. See Passenger Automobiles and Partial Business Use of Listed Property in Publication 534. 2) 7─year property. This class includes office furniture and equipment (desks, files, etc.), and appliances, carpets, furniture, etc. used in residential rental property. This class also includes any property that does not have a class life and that has not been designated by law as being in any other class. 3) 15─year property. This class includes roads and shrubbery (if depreciable). 4) Nonresidential real property. This class includes: ∙ Any real property that is not residential rental property (defined below), and ∙ Any real property that is section 1250 property with a class life of 27.5 years or more. See Publication 527 for more information. Nonresidential real property is depreciated over 31.5 years. 5) Residential rental property. This class includes any real property that is a rental building or structure (including mobile homes) for which 80% or more of the gross rental income for the tax year is rental income from dwelling units. If you live in any part of the building or structure, the gross rental income includes the fair rental value of the part you live in. This property is depreciated over 27.5 years. A dwelling unit is a house or an apartment used to provide living accommodations in a building or structure, but does not include a unit in a hotel, motel, inn, or other establishment where more than half of the units are used on a transient basis. Placed in Service Property is considered placed in service when it is in a condition or state of readiness and available for use in a trade or business, in the production of income, in a tax-exempt activity, or in a personal activity. Basis To deduct the proper amount of depreciation each year, you must first determine your basis in the property you intend to depreciate. The basis used for figuring depreciation is your original basis in the property increased by any improvements made to the property. Your original basis is usually the purchase price. However, if you acquire the property in some other way, such as by inheriting it, getting it as a gift, or building it yourself, you may have to figure your original basis in another way. Other adjustments could also affect your basis. See Chapter 14. Figuring MACRS Depreciation You can figure your MACRS depreciation in one of two ways. You can either: 1) Actually compute the deduction using the applicable depreciation method and convention over the recovery period, or 2) Use the percentage from the optional MACRS tables. The deduction is the same under both methods. See Optional Tables, later. Depreciation Methods For property in the 5- or 7-year classes, you use the double (200%) declining balance method over 5 or 7 years and a half-year convention or the mid-quarter convention, if applicable (defined later). For property in the 15─year class, you use the 150% declining balance method over 15 years and a half-year convention. You can also choose to use the 150% declining balance method over the class life (12 years for personal property with no class life). You make this election by entering "150 DB" in column (f) and "HY" for the half-year convention or "MQ," for the mid-quarter convention, in column (e), Part II of Form 4562. For these classes of property, change to the straight line method for the first tax year for which that method, when applied to the adjusted basis at the beginning of the year, will yield a larger deduction. You must use the straight line method and a mid-month convention (defined later) for nonresidential real property and residential rental property. Also see Optional Tables, later. Instead of using the declining balance method, you may elect to use the straight line method with a half-year or mid-quarter convention over the recovery period. The election to use the straight line method for a class of property applies to all property in that class that is placed in service during the tax year of the election. The election is made by entering "S/L" in column (f) and "HY," "MM," or "MQ" in column (e), Part II of Form 4562, Depreciation and Amortization. Once made, the election to use the straight line method over the recovery period may not be changed (see also Alternate MACRS Method, later). Declining balance method. To figure your MACRS deduction, first determine your declining balance rate of depreciation. This is determined by dividing the specified declining balance percentage (150% or 200%) by the recovery period. For example, for 5-year property, you divide 2.00 (200%) by 5 to get .4 (40%). For 15-year property, you divide 1.5 (150%) by 15 to get .1 (10%). Multiply the adjusted basis of the property by the declining balance rate, and apply the applicable convention to figure your depreciation for the first year. In later years, 1) Adjust your basis by subtracting the amount of depreciation allowable for the earlier years, then 2) Multiply your adjusted basis by the same rate used in the first year. Follow steps (1) and (2) each year that you use the declining balance method. Declining balance rates. The following table shows the applicable declining balance rate for each class of property and the first year for which the straight line method will give an equal or greater deduction. Class Declining Balance Rate Year 5 40.00% 4th 7 28.57% 5th 15 10.00% 7th Straight line method. To figure your MACRS deduction under the straight line method, you must figure a new depreciation rate for each tax year in the recovery period. 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. Multiply the unrecovered basis of the property by the straight line rate. You must figure the depreciation for the first year using the applicable convention (see Conventions, later). If the remaining recovery period at the beginning of the tax year is less than 1 year, the straight line rate for that tax year is 100%. Example. Using the straight line method for property with a 5-year recovery period, the straight line rate is 20% (1 ÷ 5) for the first tax year. After applying the half-year convention, the first year rate is 10% (20% ÷ 2). At the beginning of the second year, the remaining recovery period is 4-1/2 years because of the half-year convention. The straight line rate for the second year is 22.2222% (1 ÷ 4.5). To figure your depreciation deduction for the second year: 1) Subtract the depreciation taken in the first year from the basis of the property, and 2) Multiply the remaining basis by the second year rate. Residential rental and nonresidential real property. In the first year you claim depreciation for residential rental and nonresidential real property, you can only claim depreciation for the number of months the property is in use and you must use the mid-month convention (defined later). Also, for the first year of depreciation under the alternate MACRS method (described later), you must use the applicable convention to figure your depreciation deduction. Conventions In the year that you place property in service or in the year that you dispose of property, you are only allowed to claim depreciation for a part of the year. The part of the year (or convention) depends on the class of the property. A half-year convention is used to figure the deduction for property other than nonresidential real and residential rental property. Under a special rule, a mid-quarter convention may have to be used (discussed below). For nonresidential real and residential rental property, use a mid-month convention in all situations. Half-year convention. Under MACRS, the half-year convention treats all property placed in service, or disposed of, during a tax year as placed in service, or disposed of, in the middle of that tax year. A half year of depreciation is allowable for the first year property is placed in service, regardless of when the property is placed in service during the tax year. For each of the remaining years of the recovery period, you will take a full year of depreciation. If you hold the property for the entire recovery period, a half year of depreciation is allowable for the year following the end of the recovery period. If you dispose of the property before the end of the recovery period, a half year of depreciation is allowable for the year of disposition. Mid-quarter convention. Under a mid-quarter convention, all property placed in service, or disposed of, during any quarter of a tax year is treated as placed in service, or disposed of, in the middle of the quarter. A mid-quarter convention must be used instead of a half-year convention if the following conditions occur in the last 3 months of a tax year. 1) You place in service depreciable property other than nonresidential real and residential rental property, and 2) The total basis of that property is more than 40% of the total bases of all such depreciable property you place in service during the year (whether or not all of the property is subject to MACRS). For tax years beginning after March 31, 1988, you do not include in the total basis any property placed in service and disposed of during the same tax year. You can elect to have this provision apply to tax years beginning before April 1, 1988. Example. During 1992, John Joyce purchases a dishwasher for $400, which he places in service in January; used furniture for $100, which he places in service in September; and a refrigerator for $500, which he places in service in October. John uses the calendar year as his tax year. The total bases of all property placed in service in 1992 is $1,000. The basis of the refrigerator is $500, and it was placed in service during the last 3 months of his tax year. Since the basis of $500 exceeds 40% of the total bases of all property ($1,000) placed in service during 1992, John must use the mid- quarter convention for all three items. The dishwasher, refrigerator, and used furniture are 7-year property under MACRS. Mid-month convention. Under a mid-month convention all property placed in service, or disposed of, during any month is treated as placed in service, or disposed of, in the middle of that month. Optional Tables Optional depreciation tables can be used to compute annual depreciation under MACRS. The percentages in Tables A, B, and C make the change from declining balance to straight line in the year that straight line will yield a larger deduction. See Depreciation methods, earlier. How to use the tables. The following section explains how to use the optional tables for both personal property and real property. Personal property. For personal property, figure the depreciation deduction by multiplying your basis (explained earlier) in the property by a certain percentage. The percentages for the first 6 years are shown in the tables in this chapter for 5-, 7-, and 15-year property. The tables take the half-year and mid-quarter conventions into consideration in figuring percentages. Use Table A for 5─year property, Table B for 7-year property, and Table 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 place the property in service. Example 1. You purchased a stove and refrigerator and placed them in service on February 1, 1992. Your basis in the stove is $300, and your basis in the refrigerator is $500. You use the year 1 line of Table B, in the half-year convention column to compute the depreciation on the stove and refrigerator. Your 1992 depreciation deduction on the stove is $43 ($300 x .1429). Your 1992 depreciation deduction on the refrigerator is $71 ($500 x .1429). Example 2. Assume the same facts in Example 1, except you buy the refrigerator in October 1992 instead of February. You cannot use the half-year convention column to figure depreciation on the stove and refrigerator. Your basis of the refrigerator ($500), placed in service in the last 3 months of the tax year, is more than 40% of the total bases of all property ($800) placed in service during 1992. Use the mid-quarter convention columns to figure your depreciation. Because the stove was placed in service in the first quarter of the year, you use the first quarter column of Table B to find the depreciation percentage on the year 1 line. Your 1992 depreciation deduction on the stove is $75 ($300 x .25). You use the fourth quarter column of Table B to find the depreciation percentage on the refrigerator since you placed it in service in the fourth quarter of 1992. Your depreciation deduction on the refrigerator is $18 ($500 x .0357). Real property. Tables I and II, illustrated in this chapter, give the percentages for the first 6 years for real property placed in service after 1986. Table I covers residential rental property. Table II covers nonresidential real property. Choose the table for the class of property. Then find the column for the month that you placed the property in service. Use the percentages listed for that month for your depreciation deduction. The mid-month convention is considered in the percentages used in the tables. Example. You purchased a single family rental house and placed it in service on February 1, 1992. Your basis in the house is $80,000. Use the percentage from the first line (year 1) of Table I, residential rental property, Column 2 (February), to compute your depreciation. Your 1992 depreciation deduction is $2,546 ($80,000 x .03182). Additions or Improvements to Property Figure the depreciation deduction for any additions or improvements to any property as if you placed the property in service at the same time the addition or improvement was made. The MACRS class for the addition or improvement is determined by the MACRS class of the property to which the addition or improvement is made. Figure depreciation beginning on the date the addition or improvement is placed in service, or, if later, the date the property to which the addition or improvement was made is placed in service. Example. You own a residential rental house that you are depreciating under ACRS. If you put an addition onto the house, and you place the improvement in service after 1986, you use MACRS for the addition. Under MACRS, the addition would be depreciated as residential rental property. OPTIONAL MACRS TABLES Table A MACRS 5-Year Property Half-year convention Mid-quarter convention Year First Second Third Fourth quarter quarter quarter quarter 1 20.00% 35.00% 25.00% 15.00% 5.00% 2 32.00 26.00 30.00 34.00 38.00 3 19.20 15.60 18.00 20.40 22.80 4 11.52 11.01 11.37 12.24 13.68 5 11.52 11.01 11.37 11.30 10.94 6 5.76 1.38 4.26 7.06 9.58 OPTIONAL MACRS TABLES Table B MACRS 7-Year Property Half-year convention Mid-quarter convention Year First Second Third Fourth quarter quarter quarter quarter 1 14.29% 25.00% 17.85% 10.71% 3.57% 2 24.49 21.43 23.47 25.51 27.55 3 17.49 15.31 16.76 18.22 19.68 4 12.49 10.93 11.97 13.02 14.06 5 8.93 8.75 8.87 9.30 10.04 6 8.92 8.74 8.87 8.85 8.73 OPTIONAL MACRS TABLES Table C MACRS 15-Year Property Half-year convention Mid-quarter convention Year First Second Third Fourth quarter quarter quarter quarter 1 5.00% 8.75% 6.25% 3.75% 1.25% 2 9.50 9.13 9.38 9.63 9.88 3 8.55 8.21 8.44 8.66 8.89 4 7.70 7.39 7.59 7.80 8.00 5 6.93 6.65 6.83 7.02 7.20 6 6.23 5.99 6.15 6.31 6.48 Table I Residential Rental Property (27.5-year) Use the column for the month of taxable year placed in service Yr 1 2 3 4 5 6 7 8 9 10 11 12 -- ------ ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- 1 3.485% 3.182 2.879 2.576 2.273 1.970 1.667 1.364 1.061 0.758 0.455 0.152 2 3.636% 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3 3.636% 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 4 3.636% 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 5 3.636% 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 6 3.636% 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 Table II Nonresidential Real Property (31.5-year) Use the column for the month of taxable year placed in service Yr 1 2 3 4 5 6 7 8 9 10 11 12 -- ------ ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- 1 3.042% 2.778 2.513 2.249 1.984 1.720 1.455 1.190 0.926 0.661 0.397 0.132 2 3.175% 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3 3.175% 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 4 3.175% 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 5 3.175% 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 6 3.175% 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 3.175 Alternate MACRS Method If you choose, you can use an alternate MACRS method for most property. Under this method you use the straight line method of depreciation. The following chart shows the recovery periods for property you depreciate under the alternate MACRS method. Property Recovery Period Personal property with no class life .......................... 12 years Nonresidential real and residential rental property ................. 40 years Section 1245 property that is real property with no class life ............ 40 years Automobiles and light duty trucks ........................... 5 years Computers and peripheral equipment ........................ 5 years Most other property ........................... Class life You can find the class life assigned to many properties in the Table of Class Lives and Recovery Periods in Publication 534. If your property is not listed in the table, it is considered to have no class life. Use the mid-month convention for nonresidential real and residential rental property. For all other property, use the half-year or mid-quarter convention. Election. You make the election to use the alternate MACRS method by entering the depreciation on line 15, Part II of Form 4562, Depreciation and Amortization. The election of the alternate MACRS method for a class of property 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 nonresidential real and residential rental property. Once you make the election to use the alternate MACRS method you cannot change your election. Excluded Property You cannot use MACRS for certain personal property placed in service before 1987 (before August 1, 1986, if election made) that is transferred after 1986 (after July 31, 1986, if election made). Generally, if you acquired the property from a related party, or if you or a related party used the property before 1987, you may not use MACRS. Property that does not come under MACRS must be depreciated under ACRS or one of the other methods of depreciation, such as straight line or declining balance. In addition, you may elect to exclude certain property from the application of MACRS. See Publication 534 for more information. Other Rules About Depreciable Property In addition to the rules about what methods you can use, there are other rules you should be aware of with respect to depreciable property. If you dispose of depreciable property at a profit, you may have to report, as ordinary income, all or part of the profit. See Publication 544, Sales and Other Dispositions of Assets. Additional tax on preference items. If you use accelerated depreciation, you may have to file Form 6251, Alternative Minimum Tax - Individuals. Accelerated depreciation includes MACRS and ACRS and any other method that allows you to deduct more depreciation than you could deduct using a straight line method. For more information, see Publication 909, Alternative Minimum Tax for Individuals. Limits on Rental Losses Generally, you cannot deduct losses from rental real estate activities unless you have income from other passive activities. See Passive Activity Limits, discussed later. At-risk rules limit the amount of deductible losses from holding most real property placed in service after 1986. Losses from passive activities are first subject to the at-risk rules. Exception. If your rental losses are less than $25,000 ($12,500 if married filing separately), the passive activity limits probably do not apply to you. See Losses From Rental Real Estate Activities, later. At-Risk Rules The at-risk rules place a limit on the amount you can deduct as losses from activities often described as tax shelters. Holding real property (other than mineral property) placed in service before 1987 is not subject to the at-risk rules. Generally, any loss from an activity subject to the at-risk rules is allowed only to the extent of the total amount a taxpayer has at risk in the activity at the end of the tax year. A taxpayer is considered at risk in an activity to the extent of cash and the adjusted basis of other property the taxpayer contributed to the activity and certain amounts borrowed for use in the activity. See Publication 925, Passive Activity and At-Risk Rules, for more information. Passive Activity Limits 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. In general any rental activity is a passive activity. For this purpose, a rental activity generally is an activity, the income from which consists of payments principally for the use of tangible property, rather than for the performance of substantial services. Form 8582, Passive Activity Loss Limitations, is used 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. Losses From Rental Real Estate Activities You are allowed to deduct up to $25,000 ($12,500 if married filing separately and living apart from your spouse the entire year) of losses from rental real estate activities in which you actively participated during the tax year. The offset allows you to deduct up to $25,000 of otherwise unallowable losses from rental real estate activities from other income (nonpassive income). The $25,000 ($12,500) figure is reduced if your adjusted gross income is more than $100,000 ($50,000 if married filing separately and living apart from your spouse the entire year). If you lived with your spouse at any time during the year and are filing a separate return, you cannot use this special offset to reduce your nonpassive income or tax on nonpassive income. Active participation. You actively participate in a rental real estate activity if you own at least 10% of the rental property and you make management decisions in a significant and bona fide sense. Management decisions include approving new tenants, deciding on rental terms, approving expenditures and similar decisions. For these purposes, you are considered to own any portion of the property owned by your spouse. Additional information on the passive loss limits, including information on the treatment of unused disallowed passive losses and credits and the treatment of gains and losses realized on the disposition of a passive activity, is provided in Publication 925. Property used as a home. When figuring your passive activity losses, do not treat any income, deductions, gain, or loss related to the rental of property as an item related to a passive activity if you used the property as your home (that is, you used it for personal purposes for more than 14 days and more than 10% of the number of days for which it was rented at a fair rental price). How to Report Your Rental Income and Expenses Report rental income on your return for the year you actually or constructively receive it. You are considered to constructively receive income when it is made available to you, for example, by being credited to your bank account. For more information about when you constructively receive income, see Accounting Methods in Chapter 1. Expenses carried over. If you could not deduct all of your 1991 rental expenses because you used your property as a home, treat the part you could not deduct in 1991 as a 1992 rental expense. Deduct the expenses carried over to a year only up to the amount of your gross rental income for that year, even if you did not use the property as your home for that year. Where to report. Where you report rental income and expenses, including depreciation, depends on whether you provide certain services to your tenant. If you rent out buildings, rooms, or apartments, and provide only heat and light, trash collection, etc., you normally report your rental income and expenses in Part I of Schedule E (Form 1040), Supplemental Income and Loss. However, see Not Rented For Profit, earlier. If you provide additional services that are primarily for your tenant's convenience, such as regular cleaning, changing linen, or maid service, you report your rental income and expenses on Schedule C (Form 1040), Profit or Loss from Business. For information on Schedule C, see Publication 334, Tax Guide for Small Business. You also may have to pay self-employment tax on your rental income. See Publication 533, Self-Employment Tax. Schedule E Use Part I of Schedule E (Form 1040) to report your rental income and expenses. List your total income, expenses, and depreciation for each rental property. Be sure to answer the question on line 2. On line 20 of Schedule E (Form 1040), show the depreciation you are claiming. You must complete and attach Form 4562, Depreciation and Amortization, if: ∙ You are claiming depreciation on rental property placed in service during 1992, or ∙ You are claiming depreciation on any rental property that is listed property (such as a car), regardless of when it was placed in service, or ∙ You are claiming a section 179 expense deduction or amortization of costs that begins in 1992. If you have more than three rental properties, use as many Schedules E as are needed to list the properties. Complete lines 1 and 2 for each property. However, fill in the "Totals" column for lines 3, 4, 11, 19, 20, and 24 through 26 on only one Schedule E. The figures in the total column on that Schedule E should be the combined totals of all the schedules. If you need to use page 2 of Schedule E, use page 2 of the Schedule E on which you entered the combined totals. Example. Eileen Green owns a townhouse that she rents out. She receives $1,100 a month rental income. Her rental expenses for the year are as follows: Fire insurance (1-year policy) ................ $200 Mortgage interest ............................. 5,000 Fee paid to real estate company for collecting monthly rent .................... 572 General repairs ............................... 175 Real estate taxes imposed and paid in 1992 .... 800 Eileen bought the property and placed it in service on January 1, 1992. Her basis for depreciation of the townhouse is $65,000. She is using MACRS with a 27.5─year recovery period. On April 1, 1992, Eileen bought a new dishwasher for the rental property at a cost of $425. She uses MACRS with a 7─year recovery period. She uses Form 4562 to figure and report her MACRS deduction. Eileen figures her net rental income or loss for the townhouse as follows: Total rental income received ($1,100 x 12) ... $13,200 Minus Expenses: Fire insurance ........................ $200 Mortgage interest .................... 5,000 Real estate fee ...................... 572 General repairs ...................... 175 Real estate taxes .................... 800 __________ Total expenses ................................ 6,747 __________ Balance ...................................... $6,453 Minus Depreciation: On townhouse ($65,000 x 3.485%) .................. $2,265 On dishwasher ($425 x 14.29%) ..................... 61 __________ Total depreciation ............................ 2,326 __________ Net rental income for townhouse ........... $4,127 ========== Form 1098. If you paid $600 or more of mortgage interest on your rental property, you should receive a Form 1098, Mortgage Interest Statement, or a 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 the interest on line 12 of Schedule E. 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 12, write "see attached."