Long-term property is property that lasts more than one year--for example, buildings, tangible personal property like stoves and refrigerators, office or construction equipment, cars, and other vehicles. In tax parlance, such long-term property is called a capital asset because it is part of your capital investment in your rental business or investment activity.
Items you buy that are for, or related to, your rental activity that are not long-term property (such as the food you eat when traveling for your rental activity, fertilizer you use for your rental property landscaping, and chlorine you buy to clean an apartment complex swimming pool) can usually be fully deducted in the year in which you purchase them as operating expenses.
However, most types of long-term property that you buy for your rental activity must be deducted over much longer than a year. For example, rental buildings must be deducted a little at a time over many years through a process called depreciation.
You can depreciate only property that wears out, decays, gets used up, or becomes obsolete over time. Land—that is, the ground a building rests on and the surrounding area—cannot be depreciated because, for all practical purposes, it lasts forever. (If the land you own permanently disappears due to flooding, earthquake, or some other catastrophe, you’ll have a deductible casualty loss.) When you determine your depreciation deduction for a rental building or other structure, you cannot include the value of the land it rests on in its value for tax purposes. Only the cost of the building itself can be depreciated.
Unlike land, buildings and structures on land don’t last forever and, therefore, can be depreciated. Indeed, all or most of your depreciation deduction will come from the value of your rental buildings. You can depreciate any type of structure you use for your rental activity—apartment buildings, houses, duplexes, condominiums, mobile homes, swimming pools, parking lots, parking garages, tennis courts, clubhouses, and other facilities for your tenants. You can also depreciate structures that you own and use for your rental activity even though they are not used by your tenants—for example, a building you use as your rental office, or a storage shed where you keep maintenance equipment. The cost of landscaping for rental property can also be depreciated.
You can also depreciate tangible personal property that lasts for more than one year. This includes property inside a rental unit, such as stoves, refrigerators, furniture, and carpets. Other personal property that you use in connection with your rental activity can also be depreciated, even if it is not located on your rental property—for example, a computer, fax machine, cell phone, lawn mower, or automobile you use to conduct your rental activity.
How Depreciation Works
At its core, depreciation is simple: You figure out how much the property is worth for tax purposes (the property’s basis), how long the IRS says you must depreciate it for (its recovery period), and then you deduct a certain percentage of its basis each year during its recovery period. Rental buildings are depreciated over 27.5 years. The recovery periods for personal property—office furniture and computers, for example—are much shorter, usually five or seven years. This means you’ll get your full depreciation deduction much more quickly. It is to a landlord’s advantage to be able to classify as much rental property as possible as personal property, rather than real property.
Regular and Bonus Depreciation
For 2012 and 2013, you can depreciate land improvements using either:
- regular depreciation, or
- bonus depreciation.
First-year bonus depreciation is a special depreciation deduction that was enacted to help boost the economy. With bonus depreciation, you can deduct a specified percentage of your property's cost in a single year and depreciate the rest using regular depreciation. For calendar year 2012 and 2013, the first-year depreciation deduction is 50%. Bonus depreciation is scheduled to expire in 2014.
How Much You Depreciate Each Year
To depreciate buildings using regular depreciation, use the straight-line method, which is the simplest—though the slowest—depreciation method. Deduct an equal amount of the property’s basis each year, except for the first and last years. Thus, you deduct approximately 1/27th of the basis of residential real property each year.
Personal property is usually depreciated using the Modified Accelerated Cost Recovery System, or MACRS. You can ordinarily use three different methods to calculate personal property depreciation under MACRS: straight-line depreciation or one of two accelerated depreciation methods. Accelerated depreciation allows you to get larger deductions in the first few years you own an asset
You can figure out the amount of your yearly depreciation deduction using depreciation tables prepared by the IRS. These tables factor in the depreciation convention and method. They are all available in IRS Publication 946, How to Depreciate Property, available on the IRS website.
Tax Reporting and Record Keeping for Depreciation
You must report depreciation on IRS Form 4562, Depreciation and Amortization. Carry over the amount of your depreciation to your Schedule E and subtract it from your gross rental income along with your other rental expenses.You need to keep accurate records for each asset you depreciate showing:
- a description of the asset
- when and how you purchased the property
- the date it was placed in service
- its original cost
- the percentage of time you use it for business
- the amount of depreciation you took for the asset in prior years, if any
- the asset’s depreciable basis
- the depreciation method used
- the length of the depreciation period, and
- the amount of depreciation you deducted for the year.
If you use tax preparation software, it should create a worksheet containing this information.
For more on deducting long-term assets, see Current vs. Capital Expenses.
Depreciation is a great deal for landlords, so it's crucial that you understand how to calculate and take the deduction. See Every Landlord's Tax Deduction Guide for more on the subject of depreciation as well as the alternative of Section 179 expensing.