Debits & Credits

Calculating Depreciation on Residential Real Estate

by Douglas Schultz & Alex Yarmolinsky

Q. The Bush administration and Congress recently enacted new depreciation rules that are favorable to property owners. What are the rules regarding depreciation of residential real estate?

A. The new depreciation rules are designed to spur capital investment in many sectors of the economy. Rental property owners may benefit from the new depreciation rules. The following is an overview of the current depreciation rules applicable to residential rental real estate.

The Basics
You recover your cost in income-producing property through yearly tax deductions. You accomplish this by depreciating your property; that is, by deducting some of the cost on your tax return each year. Three factors determine how much depreciation you can deduct: your basis in the property, the recovery period for the property and the depreciation method used. You can deduct depreciation only on the part of your property used for rental purposes. Depreciation reduces your basis for figuring gain or loss on a later sale or exchange.

Depreciable Basis
The depreciable basis of property used in a rental activity is generally its cost or other basis (such as a donor’s basis, if you received the property as a gift) when you acquired it. However, costs related to land are not depreciable.

Recovery Periods
Property that you placed in service during 2003 for residential housing use generally falls into one of the following classes:

5-year property: This class includes machinery and equipment, such as computers and peripheral equipment, office machinery, automobiles and light trucks. This class also includes personal property used in residential rental real estate activity such as appliances, carpeting, furniture, light fixtures, etc.
7-year property: This class includes office furniture and equipment (desks, files, etc.). This class also includes any property that does not have a class life and that has not been designated by law as being in any other class.
15-year property: This class includes land improvements, such as roads, shrubbery and landscaping.
Residential rental property: This class includes any real property that is a rental building or structure for which 80 percent or more of the gross rental income for the tax year is from dwelling units. The recovery period for residential rental property is 27.5 years.

Depreciation Methods Used
After you have established which recovery period applies to your property, you must then determine what method of depreciation to use. Generally, there are two basic methods: accelerated and straight-line.

Accelerated Depreciation for Personal Property: Properties in the 5-year or 7-year class are depreciated at the 200 percent declining balance method. For property in the 15-year class, use the 150 percent declining balance method.
Straight-line Depreciation for Real Property: You must use the straight-line method for buildings and structural components.

Bonus Depreciation
A special depreciation allowance is available for qualified property you placed in service after September 10, 2001, and before January 1, 2005. The allowance is a depreciation deduction equal to 30 percent or 50 percent of the property’s depreciable basis. The special depreciation allowance is figured before you calculate your regular depreciation. To qualify for the bonus depreciation allowance, your property must meet the following requirements:

It must be property that is depreciated under a recovery period of 20 years or less (i.e., appliances, carpeting, furnishings and fixtures, landscaping, etc.) or certain qualified nonresidential leasehold improvements to a building’s interior (e.g., interior remodeling to a street-level restaurant or retail shop).
And, it must meet the following tests:
Placed in service date test. Two different rate schedules are available for bonus depreciation based upon when the property was placed into service: from September 11, 2001 through May 5, 2003, the rate is 30 percent; and from May 6, 2003 though January 1, 2005, the rate increases to 50 percent. Original use test. “Original use” means the first use to which the property is put, whether or not by you. In other words, it must be new.

The bonus depreciation provisions described above are the centerpieces of the recent tax legislation. Although bonus depreciation cannot be claimed on residential structural property, it can be claimed on personal property and certain nonresidential leasehold improvements. A cost segregation study may help you identify components of remodeling work done to residential property that may qualify for bonus depreciation. Please note: the new bonus depreciation rules are permitted under federal tax laws, but are not allowed under California’s tax laws.

Depreciation of real estate has always been an important factor in apartment ownership. It reduces taxes and thereby increases cash flow. At the same time, your property is probably appreciating in value. Knowledge of the ever-changing depreciation rules and how they potentially apply to your property can help you realize a greater return on your investment.

The opinions expressed in this article are those of the authors and do not necessarily reflect the viewpoint of the SFAA or the San Francisco Apartment Magazine. Doug Schultz is a CPA and partner in the tax practice at Burr, Pilger and Mayer. Alex Yarmolinsky is a CPA and a manager in the tax practice at Burr, Pilger and Mayer. Both can be contacted at 415-421-5757. Copyright © 2004.