US Internal Revenue Service: p527--1997

8/14/2019 US Internal Revenue Service: p527--1997

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ContentsIntroduction ........................................ 1

Rental Income ..................................... 2

Rental Expenses ................................ 2Repairs and Improvements ............ 2Other Expenses .............................. 3Renting Part of Property ................. 3Condominiums and Cooperatives .. 4

Property Changed to Rental Use ... 4Not Rented for Profit ....................... 4

Personal Use of Vacation Home orDwelling Unit ............................... 4

Dwelling Unit Used as Home ......... 4Figuring Days of Personal Use ...... 5How To Divide Expenses ............... 6How To Figure Rental Income and

Deductions ............................... 6

Depreciation ........................................ 6Modified Accelerated Cost Recovery

System (MACRS) .................... 8MACRS Depreciation Under GDS .. 10Optional Tables ............................... 11MACRS Depreciation Under ADS .. 12

Casualties and Thefts ........................ 12

Limits on Rental Losses ................... 13At-Risk Rules .................................. 13Passive Activity Limits .................... 13

How To Report Rental Income andExpenses ...................................... 14

How To Get More Information .......... 18

Index .................................................... 19

Important ReminderForeign source income. If you are a U.S.citizen with income from sources outside theUnited States (foreign income) , you mustreport all such income on your tax return un-less it is exempt by U.S. law. This is truewhether you live inside or outside the UnitedStates and whether or not you receive a FormW-2 or 1099 from the foreign payor. This ap-plies to earned income (such as wages andtips) as well as unearned income (such asinterest, dividends, capital gains, pensions,rents, and royalties).

If you live outside the United States, youmay be able to exclude part or all of yourforeign source earned income. For details,see Publication 54, Tax Guide for U.S. Citi- zens and Resident Aliens Abroad .

IntroductionThis publication discusses rental income andexpenses, including depreciation, and ex-plains how to report them on your return. Italso covers casualty losses on rental propertyand the passive activity limits and at-riskrules.

This publication is designed for those whoonly rent out a few residential dwelling units.

Sale of rental property. For information onhow to figure and report any gain or loss fromthe sale or other disposition of your rental

Departmentof theTreasury

InternalRevenueService

Publication 527Cat. No. 15052W

ResidentialRentalProperty(IncludingRental ofVa cat ion Homes)

For use in preparing

1997 Returns

Get forms and other information faster and easier by:COMPUTER

World Wide Web www.irs.ustreas.gov FTP ftp.irs.ustreas.gov IRIS at FedWorld (703) 321-8020

FAX From your FAX machine, dial (703) 368-9694See How To Get More Information in this publication.


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property, get Publication 544, Sales and Other Dispositions of Assets.

Sale of main home used as rental property. For information on how to figureand report any gain or loss from the sale orother disposition of your main home that youalso used as rental property, get Publication523, Selling Your Home .

Useful ItemsYou may want to see:

Publication463 Travel, Entertainment, Gift, and

Car Expenses

534 Depreciating Property Placed inService Before 1987

535 Business Expenses

547 Casualties, Disasters, and Thefts(Business and Nonbusiness)

551 Basis of Assets

925 Passive Activity and At-Risk Rules

946 How To Depreciate Property

Form (and Instructions)

4562 Depreciation and Amortization

5213 Election To Postpone Determi-nation as To Whether thePresumption Applies That an Ac-tivity Is Engaged in for Profit

6251 Alternative MinimumTaxIndividuals

8582 Passive Activity Loss Limitations

Schedule E Supplemental Income andLoss

See How To Get More Information near theend of this publication for information aboutgetting these publications and forms.

Rental IncomeYou generally must include in your gross in-come all amounts you receive as rent. Rentalincome is any payment you receive for theuse or occupation of property. In addition toamounts you receive as normal rent pay-ments, there are other amounts that may berental income.

Advance rent. Advance rent is any amountyou receive before the period that it covers.Include advance rent in your rental income inthe year you receive it regardless of the pe-riod covered or the method of accounting you

use.Example. You sign a 10year lease to

rent your property. In the first year, you re-ceive $5,000 for the first year's rent and$5,000 as rent for the last year of the lease.You must include $10,000 in your income inthe first year.

Security deposits. Do not include a securitydeposit in your income when you receive it ifyou plan to return it to your tenant at the endof the lease. But if you keep part or all of thesecurity deposit during any year because yourtenant does not live up to the terms of thelease, include the amount you keep in yourincome in that year.

If an amount called a security deposit isto be used as a final payment of rent, it isadvance rent. Include it in your income whenyou receive it.

Payment for canceling a lease. If yourtenant pays you to cancel a lease, the amountyou receive is rent. Include the payment inyour income in the year you receive it re-gardless of your method of accounting.

Expenses paid by tenant. If your tenantpays any of your expenses, the payments arerental income. You must include them in yourincome. You can deduct the expenses if theyare deductible rental expenses. See Rental Expenses , later, for more information.

Example 1. The water and sewage bill foryour rental property is mailed to the property.Under the terms of the lease, your tenantdoes not have to pay this bill. Your tenantpays the bill and deducts it from the normalrent payment.

Include in your rental income both the netamount of the rent payment and the amountthe tenant paid for the utility bill. You can in-clude the amount of the bill as a rental ex-pense.

Example 2. While you are out of town,the furnace in your rental property stopsworking. Your tenant pays for the necessaryrepairs and deducts the repair bill from therent payment.

Include in your rental income both the netamount of the rent payment and the amountthe tenant paid for the repairs. You can in-clude the cost of the repairs as a rental ex-pense.

Property or services. If you receive propertyor services, instead of money, as rent, includethe fair market value of the property or ser-vices in your rental income.

If the services are provided at an agreedupon or specified price, that price is the fairmarket value unless there is evidence to thecontrary.

Example. Your tenant is a painter. Heoffers to paint your rental property instead ofpaying 2 months' rent. You accept his offer.

Include in your rental income the amountthe tenant would have paid for 2 months' rent.You can include that same amount as a rentalexpense for painting your property.

Lease with option to buy. If the rentalagreement gives the tenant the right to buyyour rental property, the payments you re-ceive under the agreement are generallyrental income. If, however, your tenant exer-cises the right to buy the property, the pay-ments you receive for the period after the dateof sale are part of the selling price.

Rental of property also used as a home.If you rent property that you also use as yourhome and you rent it for less than 15 daysduring the tax year, do not include the rentyou receive in your gross income. You cannotdeduct rental expenses. However, you candeduct on Schedule A of Form 1040 the in-terest, taxes, and casualty and theft lossesthat are allowed for non-rental property. SeePersonal Use of Vacation Home or Dwelling Unit, later.

Part interest. If you own a part interest inrental property, you must report your part ofthe rental income from the property.

Rental ExpensesThis part discusses repairs and certain otherexpenses of renting property that you ordi-narily can deduct from your gross rental in-come. It includes information on the expensesyou can deduct if you rent a condominium orcooperative apartment, if you rent part of yourproperty, or if you change your property torental use. Depreciation, which you can alsodeduct from your gross rental income, is dis-

cussed later.

Part interest. If you own a part interest inrental property, you can deduct your part ofthe expenses that you paid.

When to deduct. You generally deduct yourrental expenses in the year you pay or incurthem.

Vacant rental property. If you hold propertyfor rental purposes, you may be able to de-duct your ordinary and necessary expensesfor managing, conserving, or maintaining theproperty while the property is vacant. How-ever, you cannot deduct any loss of rental

income for the period the property is vacant.Pre-rental expenses. You can deductyour ordinary and necessary expenses formanaging, conserving, or maintaining rentalproperty from the time you make it availablefor rent.

Expenses for rental property sold. Ifyou sell property you held for rental purposes,you can deduct the ordinary and necessaryexpenses for managing, conserving, ormaintaining the property until it is sold.

Personal use of rental property. If yousometimes use your rental property for per-sonal purposes, you must divide your ex-penses between rental and personal use.Also, your rental expense deductions may be

limited. See Personal Use of Vacation Home or Dwelling Unit, later.

Repairs and ImprovementsYou can deduct the cost of repairs that youmake to your rental property. You cannot de-duct the cost of improvements. You recoverthe cost of improvements by taking depreci-ation (explained later).

Separate the costs of repairs and im-provements, and keep accurate records. Youwill need to know the cost of improvementswhen you sell or depreciate your property.

Repairs. A repair keeps your property ingood operating condition. It does not mate-rially add to the value of your property orsubstantially prolong its life. Repainting yourproperty inside or out, fixing gutters or floors,fixing leaks, plastering, and replacing brokenwindows are examples of repairs.

If you make repairs as part of an extensiveremodeling or restoration of your property, thewhole job is an improvement.

Improvements. An improvement adds to thevalue of property, prolongs its useful life, oradapts it to new uses. Table 1 shows exam-ples of many improvements.

If you make an improvement to property,the cost of the improvement must be capital-ized. The capitalized cost can generally be

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Table 1. Examples of ImprovementsCaution: Work you do (or have done) on your home that does not add much to either the value or the life of the property, but rather keeps the property in good condition, is considered a repair, not an improvement.

AdditionsBedroomBathroomDeckGaragePorch

Patio

Lawn & GroundsLandscapingDrivewayWalkwayFenceRetaining wallSprinkler systemSwimming pool

MiscellaneousStorm windows, doorsNew roofCentral vacuumWiring upgrades

Satellite dishSecurity system

Heating & Air ConditioningHeating systemCentral air conditioningFurnaceDuct workCentral humidifier

Filtration system

PlumbingSeptic systemWater heaterSoft water systemFiltration system

Interior ImprovementsBuilt-in appliancesKitchen modernizationFlooringWall-to-wall carpeting

InsulationAttic

Walls, floorPipes, duct work

Travel expenses. You can deduct the ordi-nary and necessary costs of traveling awayfrom home if the primary purpose of the tripwas to collect rental income or to manage,conserve, or maintain your rental property.You must properly allocate your expensesbetween rental and nonrental activities. Forinformation on travel expenses, see Publica-tion 463.

To deduct travel expenses, you must keeprecords that follow the rules in chapter 5 ofPublication 463.

Local transportation expenses. You candeduct your ordinary and necessary localtransportation expenses if you incur them tocollect rental income or to manage, conserve,or maintain your rental property.

Generally, if you use your personal car,pickup truck, or light van for rental activities,you can deduct the expenses using one oftwo methods: actual expenses or the stand-ard mileage rate. The standard mileage ratefor 1997 is 31.5 cents a mile for all businessmiles. For more information, see chapter 4of Publication 463.

To deduct car expenses under eithermethod, you must keep records that followthe rules in chapter 5 of Publication 463.

In addition, you must complete Part V ofForm 4562, and attach it to your tax return.

Tax return preparation. You can deduct,as a rental expense, the part of tax returnpreparation fees you paid to prepare Part Iof Schedule E (Form 1040). You can alsodeduct, as a rental expense, any expense youpaid to resolve a tax underpayment related toyour rental activities. On your 1997 ScheduleE you can deduct fees paid in 1997 to preparePart I of your 1996 Schedule E.

Part interest in property. If you own a partinterest in rental property, you can deductyour part of the expenses that you paid.

Renting Part of PropertyIf you rent part of your property, you mustdivide certain expenses between the part ofthe property used for rental purposes and thepart of the property used for personal pur-poses, as though you actually had two sepa-rate 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 otherpart, subject to certain limitations, only if youitemize your deductions. You can also deductas a rental expense a part of other expensesthat normally are nondeductible personal ex-penses, such as expenses for electricity, orpainting the outside of your house. You can-not deduct any part of the cost of a singlephone line even if your tenants have unlimiteduse of it.

You do not have to divide the expensesthat belong only to the rental part of yourproperty. If you paint a room that you rent,or if you pay premiums for liability insurancein connection with renting a room in yourhome, your entire cost is a rental expense. Ifyou install a second phone line strictly for yourtenant's use, all of the cost of the second lineis deductible as a rental expense. You candeduct depreciation, discussed later, on thepart of the property used for rental purposesas well as on the furniture and equipment youuse for these purposes.

depreciated as if the improvement were sep-arate property.

Other ExpensesOther expenses you can deduct from yourgross rental income include advertising,

janitor and maid service, utilities, fire and li-ability insurance, taxes, interest, commissionsfor the collection of rent, ordinary and neces-sary travel and transportation, and other ex-penses discussed below.

Rental payments for property. You candeduct the rent you pay for property that youuse for rental purposes. If you buy aleasehold for rental purposes, you can deductan equal part of the cost each year over theterm of the lease.

Rental of equipment. You can deduct therent you pay for equipment that you use forrental purposes. However, in some cases,lease contracts are actually purchase con-tracts. If so, you cannot deduct these pay-ments. You can recover the cost of purchasedequipment through depreciation.

Insurance premiums. You can deduct in-surance premiums you pay for rental prop-erty. If you pay a premium for more than oneyear in advance, each year you can deductthe part of the premium payment that will ap-ply to that year. You cannot deduct the totalpremium in the year you pay it.

Local benefit taxes. Generally, you cannotdeduct charges for local benefits that increasethe value of your property, such as chargesfor putting in streets, sidewalks, or water andsewer systems. These charges are capitalexpenditures that you cannot depreciate. Youmust add them to the basis of your property.You can deduct local benefit taxes if they arefor maintaining, repairing, or paying interestcharges for the benefits.

Interest expense. You can deduct mortgageinterest you pay on your rental property.Chapter 8 of Publication 535 explains mort-gage interest in detail.

Points. The term points is often used todescribe some of the charges paid by a bor-rower when taking out a loan or a mortgage.These charges are also called loan originationfees, maximum loan charges, or premiumcharges. If any of these charges are solely forthe use of money, they are interest.

Points are prepaid interest. You cannotdeduct prepaid interest all in one tax year.Instead, you deduct part of the interest each

tax year during the period of the loan, unlessthe interest must be capitalized.To figure how much to deduct each year,

divide the part of the loan period falling withinyour tax year by the total loan period. Thenmultiply the answer by the amount of prepaidinterest. For example, if your tax year is acalendar year and you take out a 10yearloan on October 1, 3 months of the loan pe-riod fall in the tax year in which the loan pe-riod began. You can deduct 3/120 of theprepaid interest on your tax return for thatyear. You can deduct 12/120 of the prepaidinterest on your tax return for the next year.

If your mortgage ends early due to a pre-payment, refinancing, foreclosure, or similarevent, deduct any remaining balance of theprepaid interest in the year the mortgageends.

Expenses paid to obtain a mortgage.Expenses you pay to obtain a mortgage onyour rental property cannot be deducted asinterest. These expenses, which includemortgage commissions, abstract fees, andrecording fees, are capital expenses. You canamortize them over the life of the mortgage.

Charges for services. You can deductcharges you pay for services provided foryour rental property, such as water, sewer,and trash collection.

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How to divide expenses. If an expense isfor both rental use and personal use, suchas mortgage interest or heat for the entirehouse, you must divide the expense betweenrental use and personal use. You can use anyreasonable method for dividing the expense.It may be reasonable to divide the cost ofsome items (for example, water) based on thenumber of people using them. However, thetwo most common methods for dividing anexpense are one based on the number ofrooms in your home and one based on thesquare footage of your home.

Example. You rent a room in your house.The room is 12 15 feet, or 180 square feet.Your entire house has 1,800 square feet offloor space. You can deduct as a rental ex-pense 10% of any expense that must be di-vided between rental use and personal use.If your heating bill for the year for the entirehouse was $600, $60 ($600 10%) is a rentalexpense. The balance, $540, is a personalexpense and you cannot deduct it.

Condominiumsand CooperativesIf you rent out a condominium or a cooper-

ative apartment, some special rules apply toyou even though you receive the same taxtreatment as other owners of rental property.Condominiums are treated differently fromcooperatives.

CondominiumIf you own a condominium, you own outrighta dwelling unit in a multi-unit building. Youalso own a share of the common elementsof the structure, such as land, lobbies, eleva-tors, and service areas. You and the othercondominium owners may pay dues or as-sessments to a special corporation that is or-ganized to take care of the common ele-ments.

If you rent your condominium to others,you can deduct depreciation, repairs, upkeep,dues, and other expenses, such as interestand taxes, and assessments for the care ofthe common parts of the structure. You can-not deduct special assessments you pay toa condominium management corporation forimprovements. But you may be able to re-cover your share of the cost of any improve-ment by taking depreciation.

CooperativeIf you have a cooperative apartment that yourent to others, you can usually deduct, as arental expense, all the maintenance fees youpay to the cooperative housing corporation.However, you cannot deduct a payment ear-marked for a capital asset or improvement,or otherwise charged to the corporation'scapital account. For example, you cannotdeduct a payment used to pave a communityparking lot, install a new roof, or pay theprincipal of the corporation's mortgage. Youmust add the payment to the basis of yourstock in the corporation.

Treat as a capital cost the amount youwere assessed for capital items. This cannotbe more than the amount by which your pay-ments to the corporation exceeded your shareof the corporation's mortgage interest andreal estate taxes.

Your share of interest and taxes is theamount the corporation elected to allocate toyou, if it reasonably reflects those expenses

for your apartment. Otherwise, figure yourshare in the following way.

1) Divide the number of your shares ofstock by the total number of shares out-standing, including any shares held bythe corporation.

2) Multiply the corporation's deductible in-terest by the number you figured in (1).This is your share of the interest.

3) Multiply the corporation's deductible

taxes by the number you figured in (1).This is your share of the taxes.

In addition to the maintenance fees paidto the cooperative housing corporation, youcan deduct your direct payments for repairs,upkeep, and other rental expenses, includinginterest paid on a loan used to buy your stockin the corporation. The depreciation deductionallowed for cooperative apartments is dis-cussed later.

Property Changedto Rental UseIf you change your home or other property (ora part of it) to rental use at any time other than

at the beginning of your tax year, you mustdivide yearly expenses, such as depreciation,taxes, and insurance, between rental use andpersonal use.

You can deduct as rental expenses onlythe part of the expense that is for the part ofthe year the property was used or held forrental purposes.

You cannot deduct depreciation or insur-ance for the part of the year the property washeld for personal use. However, you can de-duct the allowable part of the interest and taxexpenses for the part of the year the propertywas held for personal use as an itemizeddeduction on Schedule A (Form 1040).

Example. Your tax year is a calendaryear. You moved from your home in May andstarted renting it out on June 1. You can de-duct as rental expenses seven-twelfths ofyour yearly expenses, such as taxes and in-surance.

Starting with June, you can deduct asrental expenses the amounts you pay foritems generally billed monthly, such as utili-ties.

Not Rented for ProfitIf you do not rent your property to make aprofit, you can deduct your rental expensesonly up to the amount of your rental income.You cannot carry forward your rental ex-penses that are more than your rental in-come. For more information about the rulesfor an activity not engaged in for profit, seechapter 1 of Publication 535.

Where to report. Report your not-for-profitrental income on line 22, Form 1040. Deductyour mortgage interest, real estate taxes, andcasualty losses on the appropriate lines ofSchedule A (Form 1040).

Claim your other expenses, subject to therules explained in chapter 1 of Publication535, as miscellaneous itemized deductionson line 22 of Schedule A. You can deductthese expenses only if they, together withcertain other miscellaneous itemized de-ductions, total more than 2% of your adjustedgross income. For more information about

miscellaneous deductions, see Publication529.

Postponing decision. If your rental incomeis more than your rental expenses for at least3 years out of a period of 5 consecutive years,you are presumed to be renting your propertyto make a profit. You may choose to postponethe decision of whether the rental is for profitby filing Form 5213 , Election To Postpone Determination as To Whether the Presumption Applies That an Activity Is En- gaged in for Profit .

See Publication 535 for more information.

Personal Use ofVacation Home orDwelling UnitIf you have any personal use of a vacationhome or other dwelling unit that you rent out,you must divide your expenses betweenrental use and personal use. See Figuring Days of Personal Use and How To Divide Expenses , later.

If you use the dwelling unit as a home andyou rent it for fewer than 15 days during theyear, do not include any of the rent in yourincome and do not deduct any of the rentalexpenses. If you rent out the dwelling unit for15 or more days, you must include the rentin your income and, if you have a net loss,you may not be able to deduct all of the rentalexpenses. See How To Figure Income and Deductions , later.

Dwelling unit. The rules in this section applyto vacation homes and other dwelling units.A dwelling unit includes a house, apartment,condominium, mobile home, boat, or similarproperty. A dwelling unit has basic living ac-commodations, such as sleeping space, atoilet, and cooking facilities. A dwelling unitdoes not include property used solely as ahotel, motel, inn, or similar establishment.

Property is used solely as a hotel, motel,inn, or similar establishment if it is regularlyavailable for occupancy by paying customersand is not used by an owner as a home duringthe year.

Example. You rent out a room in yourhome that is always available for short-termoccupancy by paying customers. You do notuse the room yourself and you allow onlypaying customers to use the room. The roomis used solely as a hotel, motel, inn, or similarestablishment and is not a dwelling unit.

Dwelling Unit Used as HomeYou use a dwelling unit as a home during thetax year if you use it for personal purposesmore than the greater of:

1) 14 days, or

2) 10% of the total days it is rented to oth-ers at a fair rental price.

See Figuring Days of Personal Use later.If a dwelling unit is used for personal pur-

poses on a day it is rented at a fair rentalprice, do not count that day as a day of rentalin applying (2) above. Instead, count it as aday of personal use in applying both (1) and(2) above. This rule does not apply when di-viding expenses between rental and personaluse.

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Fair rental price. A fair rental price for yourproperty generally is an amount that a personwho is not related to you would be willing topay. The rent you charge is not a fair rentalprice if it is substantially less than the rentscharged for other properties that are similarto your property.

Ask yourself the following questions whencomparing 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 propertiesprobably are not similar.

Examples. The following examples showhow to determine whether you used yourrental property as a home.

Example 1. You converted the basementof your home into an apartment with abedroom, a bathroom, and a small kitchen.You rent the apartment at a fair rental priceto college students during the regular schoolyear. You rent to them on a 9-month (273days) lease.

During the summer, your brothers staywith you for a month (30 days) and live in theapartment rent free.

Your basement apartment is used as ahome because you use it for personal use for30 days. That is more than the greater of 14days or 10% of the total days it is rented.

Example 2. You rent out the guestbedroom in your home at a fair rental priceduring the local college's homecoming, com-mencement, and football weekends (a totalof 27 days). Your sister-in-law stays in theroom, rent free, for the last 3 weeks (21 days)

in July.The room is used as a home because youuse it for personal use for 21 days. That ismore than the greater of 14 days or 10% ofthe total days it is rented.

Example 3. You own a cottage at theshore. You rent it out at a fair rental price fromJune 1 through August 31, a total of 92 days.The tenant who rented the cottage for themonth of July was unable to use it from July4 through July 8. The tenant allowed you touse the cottage for those 5 days. The tenantdid not ask for a refund of, or a reduction in,the rent. Your family used the cottage for 3of those days.

To determine the number of days the cot-tage was rented at a fair rental price, do notcount those 3 days you used it for personalpurposes. The cottage was rented at a fairrental price for 89 days (92 3).

Figuring Daysof Personal UseA day of personal use of a dwelling unit is anyday that it is used by:

1) You or any other person who has an in-terest in it, unless you rent it out to an-other owner as his or her main homeunder a shared equity financing agree-ment (defined later),

2) A member of your family or a memberof the family of any other person whohas an interest in it, unless the familymember uses the dwelling unit as his orher main home and pays a fair rentalprice. Family includes only brothers andsisters, half-brothers and half-sisters,spouses, ancestors (parents,grandparents, etc.) and lineal descend-ants (children, grandchildren, etc.),

3) Anyone under an arrangement that letsyou use some other dwelling unit, or

4) Anyone at less than a fair rental price.

Main home. If the other owner or memberof the family in (1) or (2) above has more thanone home, his or her main home is the onelived in most of the time.

Shared equity financing agreement. Thisis an agreement under which two or morepersons acquire undivided interests for morethan 50 years in an entire dwelling unit, in-cluding the land, and one or more of the co-owners is entitled to occupy the unit as hisor her main home upon payment of rent to theother co-owner or owners.

Donation of use of property. You use adwelling unit for personal purposes if:

You donate the use of the unit to a char-itable organization,

The organization sells the use of the unitat a fund-raising event, and

The purchaser uses the unit.

ExamplesThe following examples show how to deter-mine days of personal use.

Example 1. You and your neighbor areco-owners of a condominium at the beach.You rent the unit out to vacationers wheneverpossible. The unit is not used as a main homeby anyone. Your neighbor uses the unit for 2weeks every year.

Because your neighbor has an interest inthe unit, both of you are considered to haveused the unit for personal purposes duringthose 2 weeks.

Example 2. You and your neighbors areco-owners of a house under a shared equityfinancing agreement. Your neighbors live inthe house and pay you a fair rental price.

Even though your neighbors have an in-terest in the house, the days your neighborslive there are not counted as days of personaluse by you. This is because your neighborsrent 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 nointerest in this dwelling unit. He uses it as hismain home. He pays you a fair rental price forthe property.

Your son's use of the property is not per-sonal use by you because your son is usingit as his main home, he has no interest in theproperty, and he is paying you a fair rentalprice.

Example 4. You rent your beach houseto Marcia. Marcia rents her house in themountains to you. You each pay a fair rentalprice.

You are using your house for personalpurposes on the days that Marcia uses it be-cause your house is used by Marcia underan arrangement that allows you to use herhouse.

Example 5. You rent an apartment toyour mother at less than a fair rental price.You are using the apartment for personalpurposes on the days that your mother rentsit.

Days Not Countedas Personal UseSome days you spend at the dwelling unit arenot counted as days of personal use.

Repairs and maintenance. Any day that youspend working substantially full time repairingand maintaining your property is not countedas a day of personal use. Do not count sucha day as a day of personal use even if familymembers use the property for recreationalpurposes on the same day.

Example. You own a cabin in the moun-tains which you rent out during the summer.You spend 3 days at the cabin each Mayworking full time to repair anything that wasdamaged over the winter and get the cabinready for the summer. You also spend 3 dayseach September working full time to repairany damage done by renters and get thecabin ready for the winter.

These 6 days do not count as days ofpersonal use.

Use as a home before or after renting.When determining if you used your propertyas a home, the following special rule applies.Do not count as days of personal use thedays you used the property as your mainhome either before or after renting it or offer-ing it for rent in the following circumstances:

1) You rented or tried to rent the propertyfor 12 or more consecutive months, or

2) You rented or tried to rent the propertyfor a period of less than 12 consecutivemonths and the period ended becauseyou sold or exchanged the property.

This special rule does not apply when dividingexpenses between rental and personal use.

Example 1. On February 28, you movedout of the house you had lived in for 6 yearsbecause you accepted a job in another town.You rent your house at a fair rental price fromMarch 15 of that year, to May 14 of the nextyear. On the following June 1, you moveback into your old house.

To determine whether you used the houseas a home, its use as your main home fromJanuary 1 to February 28 of the tax year, andfrom June 1 to December 31 of the next yearis not counted as days of personal use.

Example 2. On January 31 of the taxyear, you moved out of the condominiumwhere you had lived for 3 years. You offeredit for rent at a fair rental price beginning onFebruary 1. You were unable to rent it untilApril. On September 15 of that year, you soldthe condominium.

Your use of the condominium from Janu-ary 1 to January 31, is not counted as per-sonal use when determining whether youused it as a home.

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How To Divide ExpensesIf you use a dwelling unit for both rental andpersonal purposes, divide your expenses be-tween the rental use and the personal usebased on the number of days used for eachpurpose. Expenses for the rental use of theunit are deductible under the rules explainedin How To Figure Rental Income and De- ductions , next. When dividing your expenses,follow these rules.

Any day that the unit is rented at a fairrental price is a day of rental use even ifyou used the unit for personal purposesthat day. This rule does not apply whendetermining whether you used the unitas a home.

Any day the unit is held out for rent butnot actually rented is not a day of rentaluse.

Example. You offer your beach cottagefor rent from June 1 through August 31 (92days). Your family uses the cottage during thelast 2 weeks in May (14 days). You were un-able to find a renter for the first week in Au-gust (7 days). The person who rented thecottage for July allowed you to use it over aweekend (2 days) without any reduction in orrefund of rent. The cottage was not used atall before May 17 or after August 31.

You figure the part of the cottage ex-penses to treat as rental expenses as follows.

1) The cottage was used for rental a totalof 85 days (92 7). The days it was heldout for rent but not rented (7 days) arenot days of rental use. The July weekend(2 days) you used it is rental use be-cause you received a fair rental price forthe weekend.

2) You used the cottage for personal pur-poses for 14 days (the last 2 weeks inMay).

3) The total use of the cottage was 99 days(14 days personal use + 85 days rentaluse). Your rental expenses are 85/99(86%) of the cottage expenses.

When determining whether you used thecottage as a home, the July weekend (2 days)you used it is personal use even though youreceived a fair rental price for the weekend.Therefore, you had 16 days of personal useand 83 days of rental use for this purpose.Because you used the cottage for personalpurposes more than 14 days and more than10% of the days of rental use, you used it asa home. If you have a net loss, you may notbe able to deduct all of the rental expenses.See Property Used as a Home in the followingdiscussion.

How To Figure RentalIncome and DeductionsHow you figure your rental income and de-ductions depends on whether the dwellingunit was used as a home and, if used as ahome, how many days the property wasrented.

Property Not Used as a HomeIf you do not use a dwelling unit as a home,report all the rental income and deduct all therental expenses. See How To Report Rental Income and Expenses , later.

Your deductible rental expenses can bemore than your gross rental income. How-ever, see Limits on Rental Losses , later.

Property Used as a HomeIf you use a dwelling unit as a home duringthe year (see Dwelling Unit Used as Home,earlier), how you figure your rental incomeand deductions depends on how many daysthe unit was rented.

Rented fewer than 15 days. If you use adwelling unit as a home and you rent it forfewer than 15 days during the year, you donot include in income any of the rental in-come. Also, you cannot deduct any expensesas rental expenses.

Rented 15 days or more. If you use adwelling unit as a home and rent it for 15 daysor more during the year, you include all yourrental income in your gross income. See How To Report Rental Income and Expenses,later. If you had a net profit from the rentalproperty for the year (that is, if your rentalincome is more than the total of your rentalexpenses, including depreciation), deduct allof your rental expenses. However, if you hada net loss, you may not be able to deduct allof your rental expenses. See Limit on Certain Expenses, next.

Limit on Certain ExpensesIf you use your rental property as a home (asexplained earlier), rented it for 15 days ormore during the year, and your rental ex-penses are more than your rental income,there is a limit on the amount you can deductfor certain rental expenses.

This limit ensures that the rental expensesare used to offset only rental income. If thetotal of these expenses exceeds the rentalincome, you cannot use the excess to offsetincome from other sources. The excess canbe carried forward to next year and treated

as rental expenses for the next year.To figure your deductible rental expensesand any carryover to next year, use Table 2,Worksheet for Figuring the Limit on Rental Deductions for a Dwelling Unit Used as a Home .

Carryover of expenses. If the total of yourrental expenses is more than your grossrental income, the expenses that you are notallowed to deduct can be carried forward tothe next year and treated as rental expensesfor the same property. Any expenses carriedforward to next year will be subject to anylimits that apply next year. You can deduct theexpenses carried over to a year only up to theamount of your rental income for that year,

even if you do not use the property as yourhome for that year.

DepreciationWhen you use your property to produce in-come, such as rents, you can recover (getback) some or all of what you paid for theproperty through tax deductions. You do thisby depreciating the property; that is, by de-ducting some of your cost on your tax returneach year.

Several factors determine how much de-preciation you can deduct. The main factorsare: (1) your basis in the property, (2) the re-

covery period for the property, and (3) thedepreciation method (including convention)used. You cannot simply deduct your mort-gage or principal payments as an expense.

You can deduct depreciation only on thepart of your property used for rental purposes.Depreciation reduces your basis for figuringgain or loss on a later sale or exchange.

You may have to use Form 4562, Depre- ciation and Amortization, to figure and reportyour depreciation. See How To Report Rental Income and Expenses, later. Also see Publi-cation 946, How To Depreciate Property.

Claiming the correct amount of depreci-ation. You should claim the correct amountof depreciation each tax year. If, in an earlieryear, you did not claim depreciation that youwere entitled to deduct, you must still reduceyour basis in the property by the amount ofdepreciation that you should have deducted.You generally cannot deduct the unclaimeddepreciation in the current year or in any latertax year. However, you may be able to claimthe correct amount of depreciation on anamended return (Form 1040X) for the earlieryear. You must file an amended return within3 years from the date you filed your originalreturn, or within 2 years from the time youpaid your tax, whichever is later. A return filedearly is considered filed on the due date.

Changing your accounting method to deduct unclaimed depreciation. If youclaimed less depreciation than allowable inan earlier year, you can change your ac-counting method to take a deduction in thecurrent year for the unclaimed depreciation.To change your accounting method, you musthave the consent of the IRS. In some in-stances, you can receive automatic consent.For more information, see chapter 1 of Publi-cation 946.

What can be depreciated. You can depre-ciate your property if it meets all the followingconditions.

1) It is used in business or held for theproduction of income (such as rentalproperty).

2) It has a determinable useful life longerthan one year.

3) It is something that wears out, gets usedup, decays, becomes obsolete, or losesvalue from natural causes.

You can depreciate both real property,other than land (discussed later), and personal property .

Real property. Real property is land and,generally, anything that is built on, growingon, or attached to land. Buildings, fences,sidewalks, and trees are real property.

Personal property. Personal property isproperty that is not real property. Furniture,appliances, and lawn mowers are personalproperty.

Rented property. If you pay rent on prop-erty, you cannot depreciate that property.Only the owner can depreciate it. If you makepermanent improvements to the property, youmay be able to depreciate the improvements.See Additions or improvements to property,later.

Land. You can never depreciate land. Thecosts of clearing, grading, planting, and land-scaping are usually all part of the cost of land.

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Table 2. Worksheet for Figuring the Limit on Rental Deductions for a Dwelling Unit Used as a Home

Use this worksheet only if you answer yes to all of the following questions. Did you use the dwelling unit as a home this year? (See Dwelling Unit Used as Home. ) Did you rent the dwelling unit 15 days or more this year? Are the total of your rental expenses and depreciation more than your rental income?

1.

2a.b.c.d.e.

3.

4a.

5.

6a.

7a.

Enter rents received

Enter the rental portion of deductible home mortgage interest (see instructions)Enter the rental portion of real estate taxesEnter the rental portion of deductible casualty and theft losses (see instructions)Enter direct rental expenses (see instructions)Fully deductible rental expenses. Add lines 2a2d

Subtract line 2e from line 1. If zero or less, enter zeroEnter the rental portion of expenses directly related to operating or maintaining the dwelling unit (suchas repairs, insurance, and utilities)Enter the rental portion of excess mortgage interest (see instructions)Add lines 4a and 4bAllowable operating expenses. Enter the smaller of line 3 or line 4c

Subtract line 4d from line 3. If zero or less, enter zero

Enter the rental portion of excess casualty and theft losses (see instructions)Enter the rental portion of depreciation of the dwelling unitAdd lines 6a and 6bAllowable excess casualty and theft losses and depreciation. Enter the smaller of line 5 orline 6cOperating expenses to be carried over to next year. Subtract line 4d from line 4cExcess casualty and theft losses and depreciation to be carried over to next year. Subtractline 6d from line 6c

Enter the amounts on lines 2e, 4d, and 6d on the appropriate lines of Schedule E (Form 1040), Part I.

b.c.d.

b.c.d.

b.

Worksheet InstructionsFollow these instructions for the worksheetabove. If you were unable to deduct all yourexpenses last year, including operatingexpenses, casualty and theft losses, anddepreciation, because of the rental incomelimit, add these unused amounts to yourexpenses for this year.

Line 2a. Figure the mortgage interest on thedwelling unit that you could deduct onSchedule A (Form 1040) if you had not rentedthe unit. Do not include interest on a loan thatdid not benefit the dwelling unit. For example,do not include interest on a home equity loanused to buy, build, or improve the dwellingunit, or to refinance such a loan. Enter therental portion of this interest on line 2a of theworksheet.

Line 2c. Figure the casualty and theft lossesrelated to the dwelling unit that you coulddeduct on Schedule A (Form 1040) if you hadnot rented the dwelling unit. To do this,complete Section A of Form 4684, treating thelosses as personal losses. On line 17 of

Line 2d. Enter the total of your rentalexpenses that are directly related only to therental activity. These include interest on loansused for rental activities other than to buy,build, or improve the dwelling unit. Alsoinclude rental agency fees, advertising, officesupplies, and depreciation on officeequipment used in your rental activity.

Line 4b. On line 2a, you entered the mortgageinterest you could deduct on Schedule A ifyou had not rented out the dwelling unit . Enteron line 4b of this worksheet the mortgageinterest you could not deduct on Schedule Abecause it is more than the limit on homemortgage interest. Do not include interest on

Line 6a. To find the rental portion of excesscasualty and theft losses you can deduct,follow these steps. Use the Form 4684 youprepared for line 2c of this worksheet.

A.

B.C.

D.

Enter the amount from line 10of Form 4684

Enter the rental portion of AEnter the amount from line 2cof the worksheet

Subtract C from B. Enter theresult here and on line 6a of theworksheet

Allocating the limited deduction. If youcannot deduct all of the amount on line 4c or6c this year, you can allocate the allowablededuction in any way you wish among theexpenses included on line 4c or 6c. Enter theamount you allocate to each expense on theappropriate line of Schedule E, Part I.

Form 4684, enter 10% of your adjusted grossincome figured without your rental incomeand expenses from the dwelling unit. Enterthe rental portion of the result from line 18 ofForm 4684 on line 2c of this worksheet. Note:Do not file this Form 4684 or use it to figureyour personal losses on Schedule A. Instead,figure the personal port ion on a separate Form4684.

a loan that did not benefit the dwelling unit(as explained in the line 2a instructions).

Cooperative apartments. If you rent yourcooperative apartment to others, you can de-duct your share of the cooperative housingcorporation's depreciation.

Figure the amount of depreciation you candeduct in the following way.

1) Figure the depreciation for all thedepreciable real property owned by thecorporation. Depreciation methods arediscussed later.

2) Subtract from (1) any depreciation forspace owned by the corporation that canbe rented but cannot be lived in by

tenant-stockholders. The result is theyearly depreciation as reduced.

3) Divide the number of your shares ofstock by the total number of shares out-standing, including any shares held bythe corporation.

4) Multiply the yearly depreciation as re-duced (from (2)) by the number you fig-ured in (3). This is your share of thecorporation's depreciation.

If you bought your cooperative stock afterits first offering, you figure the basis of the

depreciable real property to use in (1) aboveas follows.

1) Multiply your cost per share by the totalnumber of shares outstanding.

2) Add the mortgage indebtedness on theproperty on the date you bought thestock.

3) Subtract the part that is not for thedepreciable real property, such as thepart for the land.

Your depreciation deduction for the yearcannot be more than the part of your adjusted

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basis (defined later) in the stock of the cor-poration that is for your rental property.

See Cooperative apartments in chapter 1of Publication 946 for more information.

Cannot be more than basis. The total ofall your yearly depreciation deductions cannotbe more than the cost or other basis of theproperty. For this purpose, your yearly de-preciation deductions include any depreci-ation that you were allowed to claim, even ifyou did not claim it.

Depreciation systems. There are threeways to figure depreciation. The depreciationsystem you use depends on the type of assetand when the asset was placed in service.For property used in rental activities you use:

MACRS if placed in service after 1986, ACRS if placed in service after 1980 but

before 1987, or Useful lives and either straight line or an

accelerated method of depreciation, suchas the declining balance method, ifplaced in service before 1981.

If you placed property in service before1997, continue to use the same method offiguring depreciation that you used in thepast. If you need information about depreci-ating property placed in service before 1987,see Publication 534.

Section 179 election. You cannot claim thesection 179 deduction for property held toproduce rental income (unless renting prop-erty is your trade or business). See chapter2 of Publication 946.

Alternative minimum tax. If you use accel-erated depreciation, you may have to fileForm 6251, Alternative Minimum Tax Indi- viduals. Accelerated depreciation includesMACRS, ACRS, and any other method thatallows you to deduct more depreciation thanyou could deduct using a straight line method.

Modified AcceleratedCost RecoverySystem (MACRS)In general, the modified accelerated cost re-covery system (MACRS) applies to tangibleproperty placed in service during 1997.

MACRS consists of two systems that de-termine how you depreciate your property.The main system is called the General De- preciation System (GDS) . The second sys-tem is called the Alternative Depreciation System (ADS) . GDS is used to figure yourdepreciation deduction for property used inmost rental activities, unless you elect ADS.

To figure your MACRS deduction, youneed to know the following information aboutyour property:

1) Its recovery period,

2) Its placed-in-service date, and

3) Its depreciable basis.

Personal home changed to rental use. Youmust use MACRS to figure the depreciationon property used as your home and changedto rental property in 1997.

Excluded property. You cannot useMACRS for certain personal property placedin service before 1987 (before August 1,

Table 3. MACRS Recovery Periods for Property Used in RentalActivities

Type of Property

MACRS Recovery Period To Use

GeneralDepreciationSystem

AlternativeDepreciationSystem

Computers and their peripheral equipmentOffice machinery, such as:

TypewritersCalculatorsCopiers

AutomobilesLight trucks

Appliances, such as:StovesRefrigerators

CarpetsFurniture used in rental propertyAny property that does not have a class life and that

has not been designated by law as being inany other class

RoadsShrubberyFences

Residential rental property (buildings or structures)and structural components such as furnaces,water pipes, venting, etc.

Improvements and additions, such as a new roof

5 years

6 years

7 years 10 years

12 years

15 years 20 years

27.5 years 40 years

The recovery period of the propertyto which the addition orimprovement is made, determinedas if the property were placed inservice at the same time as theimprovement or addition.

Office furniture and equipment, such as:DesksFiles

5 years

5 years5 years 5 years5 years 5 years

7 years7 years 12 years7 years 12 years

7 years 12 years

15 years 20 years15 years 20 years

1986, if election made) that is transferred af-ter 1986 (after July 31, 1986, if electionmade). Generally, if you acquired the propertyfrom a related party, or if you or a relatedparty used the property before 1987, you useMACRS to depreciate the property if it hadpreviously been depreciated under ACRS andthe MACRS deduction would be less than thededuction under ACRS. Property that doesnot come under MACRS must be depreciatedunder ACRS or one of the other methods ofdepreciation, such as straight line or decliningbalance. In addition, you may elect to excludecertain property from the application ofMACRS.

See Publication 534 for more information.

Recovery Periods Under GDSEach item of property that can be depreciatedis assigned to a property class. The recoveryperiod of a piece of property depends on theclass the property is in. The property classesare:

3year property, 5year property, 7year property, 10year property, 15year property, 20year property, Nonresidential real property, and

Residential rental property.The class to which property is assigned is

determined by its class life. Class lives andrecovery periods for most assets are listed inAppendix B in Publication 946.

Under GDS, property that you placed inservice during 1997 in your rental activitiesgenerally falls into one of the followingclasses. Also see Table 3 .

1) 5year property. This class includescomputers and peripheral equipment,office machinery (typewriters, calcula-tors, copiers, etc.), automobiles, andlight trucks.

Depreciation on automobiles, certaincomputers, and cellular telephones islimited. See chapter 4 of Publication 946.

2) 7year property. This class includesoffice furniture and equipment (desks,files, etc.), and appliances, carpets, fur-niture, etc., used in residential rentalproperty. This class also includes anyproperty that does not have a class lifeand that has not been designated by lawas being in any other class.

3) 15year property. This class includesroads and shrubbery (if depreciable).

4) Residential rental property. This classincludes any real property that is a rentalbuilding or structure (including a mobile

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home) for which 80% or more of thegross rental income for the tax year isfrom dwelling units. A dwelling unit is ahouse or an apartment used to provideliving accommodations in a building orstructure, but does not include a unit ina hotel, motel, inn, or other establish-ment where more than half of the unitsare used on a transient basis. If you livein any part of the building or structure,the gross rental income includes the fairrental value of the part you live in. Resi-dential rental property is depreciatedover 27.5 years.

CAUTION

!The other recovery classes do not generally apply to property used in rental activities. These classes are not

discussed in this publication. See Publication 946 for more information.

Qualified Indian reservation property. Forthe applicable recovery period for qualifiedIndian reservation property, see Publication946.

Additions or improvements to property.Treat depreciable additions or improvementsyou make to any property as separate prop-erty items for depreciation purposes. The re-covery period for an addition or improvementto property begins on the later of:

1) The date the addition or improvement isplaced in service, or

2) The date the property to which the ad-dition or improvement was made isplaced in service.

The class and recovery period of the ad-dition or improvement is the one that wouldapply to the underlying property if it wereplaced in service at the same time as theaddition or improvement.

Example. You own a residential rentalhouse that you have been renting out since

1980 and that you are depreciating underACRS. If you put an addition onto the house,and you place the improvement in serviceafter 1986, you use MACRS for the addition.Under MACRS, the addition would be depre-ciated as residential rental property.

Placed-In-Service DateYou can begin to depreciate property whenyou place it in service in your trade or busi-ness or for the production of income. Propertyis considered placed in service in a rentalactivity when it is ready and available for aspecific use in that activity.

Example 1. On November 22, of lastyear, you purchased a dishwasher for your

rental property. The appliance was deliveredon December 7, but was not installed andready for use until January 3 of this year.Because the dishwasher was not ready foruse last year, it is not considered placed inservice until this year.

If the appliance had been ready for usewhen it was delivered in December of lastyear, it would have been considered placedin service in your tax year, even if it was notactually used until this year.

Example 2. On April 6, you purchaseda house to use as residential rental property.You made extensive repairs to the house andhad it ready for rent on July 5. You began toadvertise the house for rent in July and actu-

ally rented it out beginning September 1. Thehouse is considered placed in service in Julywhen it was ready and available for rent. Youcan begin to depreciate the house in July.

Example 3. You moved from your homein July. During August and September youmade several repairs to the house. On Octo-ber 1, you listed the property for rent with areal estate company, which rented it on De-cember 1. The property is considered placedin service on October 1, the date when it wasavailable for rent.

Depreciable BasisThe depreciable basis of property used in arental activity is generally its adjusted basiswhen you place it in service in that activity.This is its cost or other basis when you ac-quired it, adjusted for certain items occurringbefore you place it in service in the rentalactivity. Basis and adjusted basis are ex-plained in the following discussions.

However, if you used the property forpersonal purposes before changing it to rentaluse, its depreciable basis is the lesser of itsadjusted or its fair market value when youchange it to rental use. See Basis of Property Changed to Rental Use, later.

Cost BasisThe basis of property you buy is usually itscost. The cost is the amount you pay for it incash or in other property or services. Yourcost also includes amounts you pay for:

Sales tax charged on the purchase, Freight charges to obtain the property,

and

Installation and testing charges.

Loans with low or no interest. If you buyproperty on any time-payment plan thatcharges little or no interest, the basis of your

property is your stated purchase price, lessthe amount considered to be unstated inter-est. See Unstated Interest in Publication 537,Installment Sales.

Real property. If you buy real property, suchas a building and land, certain fees and otherexpenses you pay are part of your cost basisin the property.

Real estate taxes. If you buy real prop-erty and agree to pay real estate taxes on itthat were owed by the seller, the taxes youpay are treated as part of your basis in theproperty. You cannot deduct them as taxespaid.

If you reimburse the seller for real estatetaxes the seller paid for you, you can usuallydeduct that amount. Do not include thatamount in the basis of the property.

Settlement fees and other costs.Settlement fees and closing costs that are forbuying the property are part of your basis inthe property. These include:

Abstract fees, Charges for installing utility services, Legal fees, Recording fees, Surveys, Transfer taxes, Title insurance, and

Any amounts the seller owes that youagree to pay, such as back taxes or in-terest, recording or mortgage fees,charges for improvements or repairs, andsales commissions.

Some settlement fees and closing costsyou cannot include in the basis of the prop-erty are:

1) Fire insurance premiums,

2) Rent or other charges relating to occu-

pancy of the property before closing, and3) Charges connected with getting or refi-

nancing a loan, such as:

a) Points (discount points, loan origi-nation fees),

b) Mortgage insurance premiums,

c) Loan assumption fees,

d) Cost of a credit report, and

e) Fees for an appraisal required by alender.

Do not include amounts placed in escrowfor the future payment of items such as taxesand insurance.

Assumption of a mortgage. If you buyproperty and become liable for an existingmortgage on the property, your basis is theamount you pay for the property plus theamount that still must be paid on the mort-gage.

Example. You buy a building for $60,000cash and assume a mortgage of $240,000on it. Your basis is $300,000.

Land and buildings. If you buy buildingsand your cost includes the cost of the landon which they stand, you must divide the costbetween the land and the buildings to figurethe basis for depreciation of the buildings.The part of the cost that you allocate to eachasset is the ratio of the fair market value ofthat asset to the fair market value of the wholeproperty at the time you buy it.

If you are not certain of the fair marketvalues of the land and the buildings, you candivide the cost between them based on theassessed values for real estate tax purposes.

Example. You buy a house and land for$100,000. The purchase contract does notspecify how much of the purchase price is forthe house and how much is for the land.

The latest real estate tax assessment onthe property was based on an assessed valueof $80,000, of which $68,000 is for the houseand $12,000 is for the land.

You can allocate 85% ($68,000 $80,000) of the purchase price to the houseand 15% ($12,000 $80,000) of the purchase

price to the land.Your basis in the house is $85,000 (85%of $100,000) and your basis in the land is$15,000 (15% of $100,000).

Basis Other Than CostThere are many times when you cannot usecost as a basis. You cannot use cost as abasis for property that you received:

In return for services you performed, In an exchange for other property, As a gift, From your spouse, or from your former

spouse as the result of a divorce, or

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As an inheritance.

If you received property in one of theseways, see Publication 551 for information onhow to figure your basis.

Adjusted BasisBefore you can figure allowable depreciation,you may have to make certain adjustments(increases and decreases) to the basis of theproperty. The result of these adjustments tothe basis is the adjusted basis.

Increases to basis. You must increase thebasis of any property by the cost of all itemsproperly added to a capital account. This in-cludes:

The cost of any improvements having auseful life of more than one year,

Amounts spent after a casualty to restorethe damaged property,

The cost of extending utility service linesto the property, and

Legal fees, such as the cost of defendingand perfecting title.

Improvements. Add to the basis of yourproperty the amount an improvement actuallycost you, including any amount you borrowedto make the improvement. This includes alldirect costs, such as material and labor, butnot your own labor. It also includes all ex-penses related to the improvement.

For example, if you had an architect drawup plans for remodeling your property, thearchitect's fee is a part of the cost of the re-modeling. Or, if you had your lot surveyed toput up a fence, the cost of the survey is a partof the cost of the fence.

Keep separate accounts for depreciableimprovements made after you place theproperty in service in your rental activity. Forinformation on depreciating improvements,see Additions or improvements to property ,earlier, under Recovery Periods Under GDS .

CAUTION

!The cost of landscaping improvements is usually treated as an addition to the basis of the land, which is

not depreciable property. See What can bedepreciated, earlier.

Assessments for local improvements.Assessments for items which tend to increasethe value of property, such as streets andsidewalks, must be added to the basis of theproperty. For example, if your city installscurbing on the street in front of your house,and assesses you and your neighbors for thecost of curbing, you must add the assessmentto the basis of your property. Also add thecost of legal fees paid to obtain a decreasein an assessment levied against property topay for local improvements. You cannot de-duct these items as taxes or depreciate them.

Assessments for maintenance or repairor meeting interest charges are deductible astaxes. Do not add them to your basis in theproperty.

Deducting vs. capitalizing costs. Youcannot add to your basis costs that aredeductible as current expenses. However,there are certain costs you can choose eitherto deduct or to capitalize. If you capitalizethese costs, include them in your basis. If youdeduct them, do not include them in your ba-sis.

The costs you may be able to choose todeduct or to capitalize include carrying

charges, such as interest and taxes, that youmust pay to own property.

For more information about deducting orcapitalizing costs, see chapter 11 in Publica-tion 535.

Decreases to basis. You must decrease thebasis of your property by any items that rep-resent a return of your cost. Some of theseinclude:

The amount of any insurance or other

payment you receive as the result of acasualty or theft loss,

Any deductible casualty loss not coveredby insurance,

Any amount you receive for granting aneasement,

Any residential energy credit you wereallowed before 1986, if you added thecost of the energy items to the basis ofyour home,

The amount of depreciation you couldhave deducted on your tax returns underthe method of depreciation you selected.If you took less depreciation than youcould have under the method you se-lected, you must decrease the basis bythe amount you could have taken underthat method.

If you deducted more depreciationthan you should have, you must decreaseyour basis by the amount you shouldhave deducted, plus the part of the ex-cess you deducted that actually loweredyour tax liability for any year.

Basis of PropertyChanged to Rental UseWhen you change property you held for per-sonal use to rental use, (for example, you rentout your former home), you figure the basisfor depreciation using the lesser of fair marketvalue or adjusted basis.

Fair market value. This is the price at whichthe property would change hands between abuyer and a seller, neither having to buy orsell, and both having reasonable knowledgeof all the relevant facts. Sales of similarproperty, on or about the same date, may behelpful in figuring the fair market value of theproperty.

Figuring the basis. The basis for depreci-ation is the lesser of:

The fair market value of the property onthe date you changed it to rental use, or

Your adjusted basis on the date of the

changethat is, your original cost orother basis of the property, plus the costof permanent improvements or additionssince you acquired it, minus deductionsfor any casualty or theft losses claimedon earlier years' income tax returns andother decreases to basis.

Example. Several years ago you builtyour home for $40,000 on a lot that cost you$4,000. Before changing the property to rentaluse last year, you added $8,000 of permanentimprovements to the house and claimed a$1,000 deduction for a casualty loss to thehouse. Because land is not depreciable, youcan only include the cost of the house whenfiguring the basis for depreciation.

The adjusted basis of the house at thetime of the change in use is $47,000 ($40,000+ $8,000 $1,000).

On the date of the change in use, yourproperty had a fair market value of $48,000,of which $6,000 was for the land and $42,000was for the house.

The basis for depreciation on the houseis the fair market value at the date of thechange ($42,000), because it is less thanyour adjusted basis ($47,000).

MACRS DepreciationUnder GDSYou can figure your MACRS depreciationdeduction under GDS in one of two ways. Thededuction is substantially the same bothways. (The difference, if any, is slight.) Youcan either:

1) Actually compute the deduction usingthe depreciation method and conventionthat apply over the recovery period of theproperty, or

2) Use the percentage from the optionalMACRS tables.

If you actually compute the deduction, the

depreciation method you use depends on theclass of the property.

5, 7, or 15year property. For property inthe 5 or 7year class, you use the double(200%) declining balance method and a half-year convention. You must use the mid-quarter convention, if it applies. These con-ventions are explained later. For property inthe 15year class, you use the 150% declin-ing balance method and a half-year conven-tion.

You can also choose to use the 150%declining balance method and the ADS re-covery period for property in the 5, 7, or15year class. See MACRS Depreciation Under ADS , later, for the ADS recovery peri-ods. You make this election on Form 4562.In column (f), Part II, enter 150 DB.

Change from either declining balancemethod to the straight line method in the firsttax year that the straight line method givesyou a larger deduction.

You can also choose to use the straightline method with a half-year or mid-quarterconvention for 5, 7, or 15year property.The choice to use the straight line method forone item in a class of property applies to allproperty in that class that is placed in serviceduring the tax year of the election. You electthe straight line method on Form 4562. Incolumn (f), Part II, enter S/L. Once youmake this election, you cannot change to an-other method.

Residential rental property. You must usethe straight line method and a mid-monthconvention (explained later) for residentialrental property.

Declining Balance MethodTo figure your MACRS deduction, first deter-mine your declining balance rate from the ta-ble below. However, if you elect to use the150% declining balance method for 5 or7year property, figure the declining balancerate by dividing 1.5 (150%) by the ADS re-covery period for the property.

In the first tax year multiply the adjustedbasis of the property by the declining balancerate and apply the convention that applies to

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figure your depreciation. In later years, usethe following steps to figure your depreciation.

1) Adjust your basis by subtracting theamount of depreciation allowable for theearlier years.

2) Multiply your adjusted basis in (1) by thesame rate used in the first year.

See Conventions , later, for information ondepreciation in the year you dispose of prop-

erty.

Declining balance rates. The following tableshows the declining balance rate that appliesfor each class of property and the first yearfor which the straight line method will give agreater deduction. (The rates for 5 and7year property are based on the 200% de-clining balance method. The rate for 15yearproperty is based on the 150% declining bal-ance method.)

Straight Line MethodTo figure your MACRS deduction under thestraight line method, you must figure a newdepreciation rate for each tax year in the re-covery period.

For any tax year, figure the straight linerate by dividing the number 1 by the yearsremaining in the recovery period at the be-ginning of the tax year. When figuring thenumber of years remaining, you must takeinto account the convention used in the firstyear. If the remaining recovery period at thebeginning of the tax year is less than oneyear, the straight line rate for that tax year is100%.

Multiply the unadjusted basis of the prop-erty by the straight line rate. You must figurethe depreciation for the first year using theconvention that applies. (See Conventions ,later.)

Example. Using the straight line methodfor property with a 5year recovery period,the straight line rate is 20% (1 divided by 5)for the first tax year. After applying the half-year convention, the first year rate is 10%(20% divided by 2).

At the beginning of the second year, theremaining recovery period is 4 1 / 2 years be-cause of the half-year convention. Thestraight line rate for the second year is22.22% (1 divided by 4.5).

To figure your depreciation deduction forthe second year:

1) Subtract the depreciation taken in thefirst year from the basis of the property,and

2) Multiply the remaining basis in (1) by22.22%.

Residential rental property. In the first yearyou claim depreciation for residential rentalproperty, you can only claim depreciation forthe number of months the property is in use,and you must use the mid-month convention(explained later).

ConventionsIn the year that you place property in serviceor in the year that you dispose of property,you are allowed to claim depreciation for onlypart of the year. The part of the year (orconvention) depends on the class of theproperty.

A half-year convention is used to figurethe deduction for property used in rental ac-tivities other than residential rental property.However, in certain circumstances, a mid-quarter convention must be used. For resi-dential rental property, use a mid-month con-vention in all situations.

Half-year convention. The half-year con-vention treats all property placed in service,or disposed of, during a tax year as placed inservice, or disposed of, in the middle of thattax year.

A half year of depreciation is allowable forthe first year property is placed in service,regardless of when the property is placed inservice during the tax year. For each of theremaining years of the recovery period, youwill take a full year of depreciation. If you holdthe property for the entire recovery period, ahalf year of depreciation is allowable for the

year in which the recovery period ends. If youdispose of the property before the end of therecovery period, a half year of depreciation isallowable for the year of disposition.

Mid-quarter convention. Under a mid-quarter convention, all property placed inservice, or disposed of, during any quarter ofa tax year is treated as placed in service, ordisposed of, in the middle of the quarter.

A mid-quarter convention must be used incertain circumstances for property used inrental activities, other than residential rentalproperty. This convention applies if the totalbasis of such property that is placed in servicein the last 3 months of a tax year is more than40% of the total basis of all such property youplace in service during the year.

Do not include in the total basis anyproperty placed in service and disposed ofduring the same tax year.

Example. During the tax year, JohnJoyce purchased the following items to usein his rental property:

Dishwasher for $400, which he placed inservice in January;

Used furniture for $100, which he placedin service in September; and

A refrigerator for $500, which he placedin service in October.

John uses the calendar year as his tax year.The total basis of all property placed in ser-vice that year is $1,000. The $500 basis of therefrigerator placed in service during the last3 months of his tax year exceeds $400 (40% $1,000). John must use the mid-quarterconvention for all three items.

Mid-month convention. Under a mid-monthconvention, residential rental property placedin service, or disposed of, during any monthis treated as placed in service, or disposedof, in the middle of that month.

Optional TablesYou can use Table 4 to compute annual de-preciation under MACRS. The tables showthe percentages for the first 6 years. Thepercentages in Tables 4A, 4B, and 4Cmake the change from declining balance tostraight line in the year that straight line willyield a larger deduction. See Declining Bal- ance Method , earlier.

If you elect to use the straight line methodfor 5, 7, or 15year property, or the 150%declining balance method for 5 or 7 yearproperty, use the tables in Appendix A ofPublication 946.

How to use the tables. The following sectionexplains how to use the optional tables.

Figure the depreciation deduction bymultiplying your unadjusted basis in theproperty by the percentage shown in the ap-propriate table. Your unadjusted basis isyour depreciable basis without reduction fordepreciation previously claimed. See Appen- dix A of Publication 946 for complete tables.

Once you begin using an optional table tofigure depreciation, you must continue to useit for the entire recovery period unless thereis an adjustment to the basis of your propertyfor a reason other than:

1) Depreciation allowed or allowable, or

2) An addition or improvement that is de-preciated as a separate item of property.

If there is an adjustment for any other reason(for example, because of a deductible casu-alty loss) you can no longer use the table. Forthe year of the adjustment and for the re-maining recovery period, figure depreciationusing the property's adjusted basis at the endof the year and the appropriate depreciationmethod, as explained earlier under MACRS Depreciation Under GDS.

Tables 4A, 4B, and 4C. The percent-ages in these tables take into account thehalf-year and mid-quarter conventions. UseTable 4A for 5year property, Table 4B for7year property, and Table 4C for 15yearproperty. Use the percentage in the secondcolumn (half-year convention) unless youmust use the mid-quarter convention (ex-plained earlier). If you must use the mid-quarter convention, use the column that cor-responds to the calendar year quarter inwhich you placed the property in service.

Example 1. You purchased a stove andrefrigerator and placed them in service inFebruary. Your basis in the stove is $300 andyour basis in the refrigerator is $500. Both are7year property. Using the half-year conven-tion column in Table 4B, you find the de-preciation percentage for year 1 is 14.29%.

For that year your depreciation deduction is$43 ($300 .1429) on the stove and $71($500 .1429) on the refrigerator.

For year 2, you find your depreciationpercentage is 24.49%. That year's depreci-ation deduction will be $73 ($300 .2449) forthe stove and $122 ($500 .2449) for therefrigerator.

Example 2. Assume the same facts inExample 1, except you buy the refrigerator inOctober instead of February. You must usethe mid-quarter convention to figure depreci-ation on the stove and refrigerator. Therefrigerator was placed in service in the last3 months of the tax year, and its basis ($500)is more than 40% of the total basis of all

Class Declining Balance Rate Year5 40% 4th7 28.57% 5th

15 10% 7th

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property ($800) placed in service during theyear.

Because you placed the stove in servicein February, you use the first quarter columnof Table 4B and find that the depreciationpercentage for year 1 is 25%. For that yearyour depreciation deduction on the stove is$75 ($300 .25).

Because you placed the refrigerator inservice in October, you use the fourth quartercolumn of Table 4B and find that the depre-ciation percentage for year 1 is 3.57%. Yourdepreciation deduction on the refrigerator is$18 ($500 .0357).

Table 4D. Use this table for residentialrental property. Find the row for the monththat you placed the property in service. Usethe percentages listed for that month to figureyour depreciation deduction. The mid-monthconvention is taken into account in the per-centages shown in the table.

Example. You purchased a single familyrental house and placed it in service in Feb-ruary. Your basis in the house is $80,000.Using Table 4D, you find that the percentagefor property placed in service in February ofyear 1 is 3.182%. That year's depreciationdeduction is $2,546 ($80,000 .03182).

MACRS DepreciationUnder ADSIf you choose, you can use the ADS methodfor most property. Under ADS, you use thestraight line method of depreciation.

Table 3 shows the recovery periods forproperty used in rental activities that you de-preciate under ADS.

See Appendix B in Publication 946 forother property. If your property is not listed,it is considered to have no class life.

Use the mid-month convention for resi-dential rental property. For all other property,

use the half-year or mid-quarter convention.

Election. You choose to use ADS by enter-ing the depreciation on line 16, Part II of Form4562.

The election of ADS for one item in a classof property generally applies to all property inthat class that is placed in service during thetax year of the election. However, the electionapplies on a property-by-property basis forresidential rental property.

Once you choose to use ADS, you cannotchange your election.

Casualties and TheftsAs a result of a casualty or theft, you mayhave a loss related to your property. You maybe able to deduct the loss on your federalincome tax return. For information on casualtyand theft losses (business and nonbusiness),see Publication 547.

Casualty. Damage to, destruction or loss ofproperty is a casualty if it results from anidentifiable event that is sudden, unexpected,or unusual.

Theft. The unlawful taking and removing ofyour money or property with the intent to de-prive you of it is a theft.

Table 4. Optional MACRS TablesTable 4-A. MACRS 5-Year Property

Half-year convention Mid-quarter convention

Year Firstquarter

Secondquarter

Thirdquarter

Fourthquarter

123456

20.00%32.0019.2011.5211.52

5.76

35.00%26.0015.6011.0111.01

1.38

25.00%30.0018.0011.3711.37

4.26

15.00%34.0020.4012.2411.30

7.06

5.00%38.0022.8013.6810.94

9.58

Table 4-B. MACRS 7-Year Property


Year Firstquarter

Secondquarter

Thirdquarter

Fourthquarter

123456

Table 4-C. MACRS 15-Year Property


Year Firstquarter

Secondquarter

Thirdquarter

Fourthquarter

123456

Table 4-D. Residential Rental Property (27.5-year)

14.29%24.4917.4912.49

8.938.92

25.00%21.4315.3110.93

8.758.74

17.85%23.4716.7611.97

8.878.87

10.71%25.5118.2213.02

9.308.35

3.57%27.5519.6814.0610.04

8.73

5.00%9.508.557.706.936.23

8.75%9.138.217.396.655.99

6.25%9.388.447.596.836.15

3.75%9.638.667.807.026.31

1.25%9.888.898.007.206.48

Use the row for the month of the taxable year placed in service.Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Jan.Feb.MarchApr.May

JuneJulyAug.Sept.Oct.

Nov.Dec.

3.485% 3.636%3.1822.8792.5762.273

1.9701.6671.3641.0610.758

0.4550.152

3.6363.6363.6363.636

3.636

3.636

3.6363.6363.6363.636

3.636

3.636%3.6363.6363.6363.636

3.636

3.636

3.6363.6363.6363.636

3.636

3.636%3.6363.6363.6363.636

3.636

3.636

3.6363.6363.6363.636

3.636

3.636%3.6363.6363.6363.636

3.636

3.636

3.6363.6363.6363.636

3.636

3.636%3.6363.6363.6363.636

3.636

3.636

3.6363.6363.6363.636

3.636

Gain from casualty or theft. When youhave a casualty to, or theft of, your propertyand you receive money, including insurance,that is more than your adjusted basis in theproperty, you generally must report the gain.However, under certain circumstances, youmay defer the payment of tax by choosing topostpone reporting the gain. To do this, youmust generally buy replacement propertywithin 2 years after the close of the tax yearin which any part of your gain is realized. Thecost of the replacement property must beequal to or more than the net insurance or

other payment you received. For more infor-mation about casualty gains and losses tobusiness and income producing property, seePublication 547.

How to report. If you had a casualty or theftthat involved property used in your rental ac-tivity, you figure the net gain or loss in SectionB of Form 4684 , Casualties and Thefts . Also,you may have to report the net gain or lossfrom Form 4684, on Form 4797 , Sales of Business Property. (Follow the instructionsfor Form 4684.)

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Limits onRental LossesRental real estate activities are generallyconsidered passive activities, and the amountof loss you can deduct is limited. Generally,you cannot deduct losses from rental realestate activities unless you have income fromother passive activities. See Passive Activity Limits , below.

Losses from passive activities are firstsubject to the at-risk rules. At-risk rules limitthe amount of deductible losses from holdingmost real property placed in service after1986.

Exception. If your rental losses are less than$25,000 ($12,500 if married filing separately),the passive activity limits probably do not ap-ply to you. See Losses From Rental Real Estate Activities, later.

Property used as a home. If you used therental property as a home during the year, thepassive activity rules do not apply to thathome. Instead, you must follow the rules ex-

plained earlier under Personal Use of Vaca- tion Home or Dwelling Unit .

At-Risk RulesThe at-risk rules place a limit on the amountyou can deduct as losses from activities oftendescribed as tax shelters. Losses from hold-ing real property (other than mineral property)placed in service before 1987 are not subjectto the at-risk rules.

Generally, any loss from an activity subject to the at-risk rules is allowed only to theextent of the total amount you have at risk inthe activity at the end of the tax year. You areconsidered at risk in an activity to the extentof cash and the adjusted basis of other prop-erty you contributed to the activity and certainamounts borrowed for use in the activity. SeePublication 925 for more information.

Passive Activity LimitsIn general, all rental activities (except thosemeeting the exception for real estate profes-sionals, below) are passive activities. For thispurpose, a rental activity is an activity fromwhich you receive income mainly for the useof tangible property, rather than for services.

Passive activity rules. Deductions forlosses from passive activities are limited. Yougenerally cannot offset income, other thanpassive income, with losses from passiveactivities. Nor can you offset taxes on income,other than passive income, with credits re-sulting from passive activities. Any excessloss or credit is carried forward to the next taxyear.

For a detailed discussion of these rules,see Publication 925.

In general, any rental activity not meetingthe exception below is a passive activity. Youmay have to complete Form 8582 , Passive Activity Loss Limitations , to figure the amountof any passive activity loss for the current taxyear for all activities and the amount of thepassive activity loss all

Documents

US Internal Revenue Service: p527--1997