IRS Publication 17, Chapter 10, Rental Income and Expenses

Introduction

This chapter discusses rental income and expenses. It covers the following topics.

Rental income.
Rental expenses.
Personal use of dwelling unit (including vacation home).
Depreciation.
Limits on rental losses.
How to report your rental income and expenses.

If you sell or otherwise dispose of your rental property, see Publication 544, Sales and Other Dispositions of Assets.

If you have a loss from damage to, or theft of, rental property, see Publication 547, Casualties, Disasters, and Thefts.

If you rent a condominium or a cooperative apartment, some special rules apply to you even though you receive the same tax treatment as other owners of rental property. See Publication 527, Residential Rental Property, for more information.

Useful Items - You may want to see:

Publication

527 Residential Rental Property
534 Depreciating Property Placed in Service Before 1987
535 Business Expenses
925 Passive Activity and At-Risk Rules
946 How To Depreciate Property

Form (and Instructions)

4562
Depreciation and Amortization
6251
Alternative Minimum Tax—Individuals
8582
Passive Activity Loss Limitations
Schedule E (Form 1040)
Supplemental Income and Loss

Rental Income

You generally must include in your gross income all amounts you receive as rent. Rental income is any payment you receive for the use or occupation of property. In addition to amounts you receive as normal rent payments, there are other amounts that may be rental income.

When to report. If you are a cash basis taxpayer, report rental income on your return for the year you actually or constructively receive it. You are a cash basis taxpayer if you report income in the year you receive it, regardless of when it was earned. You constructively receive income when it is made available to you, for example, by being credited to your bank account.

For more information about when you constructively receive income, see Accounting Methods in chapter 1.

Advance rent. Advance rent is any amount you receive before the period that it covers. Include advance rent in your rental income in the year you receive it regardless of the period covered or the method of accounting you use.

Example.

You sign a 10-year lease to rent your property. In the first year, you receive $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 in the first year.

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

If an amount called a security deposit is to be used as a final payment of rent, it is advance rent. Include it in your income when you receive it.

Payment for canceling a lease. If your tenant pays you to cancel a lease, the amount you receive is rent. Include the payment in your income in the year you receive it regardless of your method of accounting.

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

Property or services. If you receive property or services, instead of money, as rent, include the fair market value of the property or services in your rental income.

If the services are provided at an agreed upon or specified price, that price is the fair market value unless there is evidence to the contrary.

Rental of property also used as a home. If you rent property that you also use as your home and you rent it fewer than 15 days during the tax year, do not include the rent you receive in your income and do not deduct rental expenses. However, you can deduct on Schedule A (Form 1040) the interest, taxes, and casualty and theft losses that are allowed for nonrental property. See Personal Use of Dwelling Unit (Including Vacation Home), later.

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

Rental Expenses

This part discusses repairs and certain other expenses of renting property that you ordinarily can deduct from your rental income. It includes information on the expenses you can deduct if you rent part of your property, or if you change your property to rental use. Depreciation, which you can also deduct from your rental income, is discussed later.

When to deduct. You generally deduct your rental expenses in the year you pay them.

Vacant rental property. If you hold property for rental purposes, you may be able to deduct your ordinary and necessary expenses (including depreciation) for managing, conserving, or maintaining the property while the property is vacant. However, you cannot deduct any loss of rental income for the period the property is vacant.

Pre-rental expenses. You can deduct your ordinary and necessary expenses for managing, conserving, or maintaining rental property from the time you make it available for rent.

Depreciation. You can begin to depreciate rental property when it is ready and available for rent. See Placed-in-Service Date under Depreciation, later.

Expenses for rental property sold. If you sell property you held for rental purposes, you can deduct the ordinary and necessary expenses for managing, conserving, or maintaining the property until it is sold.

Personal use of rental property. If you sometimes use your rental property for personal purposes, you must divide your expenses between rental and personal use. Also, your rental expense deductions may be limited. See Personal Use of Dwelling Unit (Including Vacation Home), later.

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

Repairs and Improvements

You can deduct the cost of repairs to your rental property. You cannot deduct the cost of improvements. You recover the cost of improvements by taking depreciation (explained later).

Separate the costs of repairs and improvements, and keep accurate records. You will need to know the cost of improvements when you sell or depreciate your property.

Repairs. A repair keeps your property in good operating condition. It does not materially add to the value of your property or substantially prolong its life. Repainting your property inside or out, fixing gutters or floors, fixing leaks, plastering, and replacing broken windows are examples of repairs.

If you make repairs as part of an extensive remodeling or restoration of your property, the whole job is an improvement.

Improvements. An improvement adds to the value of property, prolongs its useful life, or adapts it to new uses. Improvements include the following items.

Putting a recreation room in an unfinished basement.
Paneling a den.
Adding a bathroom or bedroom.
Putting decorative grillwork on a balcony.
Putting up a fence.
Putting in new plumbing or wiring.
Putting in new cabinets.
Putting on a new roof.
Paving a driveway.

If you make an improvement to property, the cost of the improvement must be capitalized. The capitalized cost can generally be depreciated as if the improvement were separate property.

Other Expenses

Other expenses you can deduct from your rental income include advertising, cleaning and maintenance services, utilities, fire and liability insurance, taxes, interest, commissions for the collection of rent, ordinary and necessary travel and transportation, and other expenses, discussed next.

Rental payments for property. You can deduct the rent you pay for property that you use for rental purposes. If you buy a leasehold for rental purposes, you can deduct an equal part of the cost each year over the term of the lease.

Rental of equipment. You can deduct the rent you pay for equipment that you use for rental purposes. However, in some cases, lease contracts are actually purchase contracts. If so, you cannot deduct these payments. You can recover the cost of purchased equipment through depreciation.

Insurance premiums paid in advance. If you pay an insurance premium for more than one year in advance, each year you can deduct the part of the premium payment that will apply to that year. You cannot deduct the total premium in the year you pay it.

Local benefit taxes. Generally, you cannot deduct charges for local benefits that increase the value of your property, such as charges for putting in streets, sidewalks, or water and sewer systems. These charges are nondepreciable capital expenditures. You must add them to the basis of your property. You can deduct local benefit taxes if they are for maintaining, repairing, or paying interest charges for the benefits.

Travel expenses. You can deduct the ordinary and necessary expenses of traveling away from home if the primary purpose of the trip was to collect rental income or to manage, conserve, or maintain your rental property. You must properly allocate your expenses between rental and nonrental activities. For information on travel expenses, see chapter 28.

To deduct travel expenses, you must keep records that follow the rules in chapter 28.

Local transportation expenses. You can deduct your ordinary and necessary local transportation expenses if you incur them to collect 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 of two methods: actual expenses or the standard mileage rate. For 2004, the standard mileage rate for all business miles is 37½ cents a mile. For more information, see chapter 28.

To deduct car expenses under either method, you must keep records that follow the rules in chapter 28. In addition, you must complete Form 4562, Part V, and attach it to your tax return.

Tax return preparation. You can deduct, as a rental expense, the part of the tax return preparation fees you paid to prepare of Schedule E (Form 1040), Part 1. You can also deduct, as a rental expense, any expense you paid to resolve a tax underpayment related to your rental activities. On your 2004 Schedule E, you can deduct fees paid in 2004 to prepare your 2003 Schedule E, Part I.

Not Rented for Profit

If you do not rent your property to make a profit, you can deduct your rental expenses only up to the amount of your rental income. You cannot carry forward to the next year any rental expenses that are more than your rental income for the year. For more information about the rules for an activity not engaged in for profit, see chapter 1 of Publication 535.

Where to report. Report your not-for-profit rental income on Form 1040, line 21. You can include your mortgage interest (if you use the property as your main home or second home), real estate taxes, and casualty losses on the appropriate lines of Form 1040, Schedule A, Itemized Deductions, if you itemize your deductions.

Claim your other rental expenses, subject to the rules explained in chapter 1 of Publication 535, as miscellaneous itemized deductions on Form 1040, Schedule A, line 22. You can deduct these expenses only if they, together with certain other miscellaneous itemized deductions, total more than 2% of your adjusted gross income.

Property Changed to Rental Use

If you change your home or other property, (or a part of it), to rental use at any time other than at the beginning of your tax year, you must divide yearly expenses, such as taxes and insurance, between rental use and personal use.

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

For depreciation purposes, treat the property as being placed in service on the conversion date.

You cannot deduct depreciation or insurance for the part of the year the property was held for personal use. However, you can include the home mortgage interest and real estate tax expenses for the part of the year the property was held for personal use as an itemized deduction on Schedule A (Form 1040).

Example.

Your tax year is the calendar year. You moved from your home in May and started renting it on June 1. You can deduct as rental expenses seven-twelfths of your yearly expenses, such as taxes and insurance.

Starting with June, you can deduct as rental expenses the amounts you pay for items generally billed monthly, such as utilities.

Renting Part of Property

If you rent part of your property, you must divide certain expenses between the part of the property used for rental purposes and the part of the property used for personal purposes, as though you actually had two separate pieces of property.

You can deduct the expenses related to the part of the property used for rental purposes, such as home mortgage interest and real estate taxes, as rental expenses on Schedule E (Form 1040). You can also deduct as a rental expense a part of other expenses that normally are nondeductible personal expenses, such as expenses for electricity or painting the outside of your house.

You can deduct the expenses for the part of the property used for personal purposes, subject to certain limitations, only if you itemize your deductions on Schedule A (Form 1040).

You cannot deduct any part of the cost of the first phone line even if your tenants have unlimited use of it.

You do not have to divide the expenses that belong only to the rental part of your property. For example, if you paint a room that you rent, or if you pay premiums for liability insurance in connection with renting a room in your home, your entire cost is a rental expense. If you install a second phone line strictly for your tenants' use, all of the cost of the second line is deductible as a rental expense. You can deduct depreciation, discussed later, on the part of the property used for rental purposes as well as on the furniture and equipment you use for rental purposes.

How to divide expenses. If an expense is for both rental use and personal use, such as mortgage interest or heat for the entire house, you must divide the expense between the rental use and the personal use. You can use any reasonable method for dividing the expense. It may be reasonable to divide the cost of some items (for example, water) based on the number of people using them. However, the two most common methods for dividing an expense are one based on the number of rooms in your home and one based on the square footage of your home.

Personal Use of Dwelling Unit (Including Vacation Home)

If you have any personal use of a dwelling unit (including a vacation home) that you rent, you must divide your expenses between rental use and personal use. See Figuring Days of Personal Use and How To Divide Expenses, later.

If you used your dwelling unit for personal purposes, it may be considered a “dwelling unit used as a home.” If it is, you cannot deduct rental expenses that are more than your rental income for the unit. See Dwelling Unit Used as Home and How To Figure Rental Income and Deductions, later. If your dwelling unit is not considered a dwelling unit used as a home, you can deduct rental expenses that are more than rental income for the unit subject to certain limits. See Limits on Rental Losses, later.

Exception for minimal rental use. If you use the dwelling unit as a home and you rent it fewer than 15 days during the year, do not include any of the rent in your income and do not deduct any of the rental expenses. See Dwelling Unit Used as Home, later.

Dwelling unit. A dwelling unit includes a house, apartment, condominium, mobile home, boat, vacation home, or similar property. A dwelling unit has basic living accommodations, such as sleeping space, a toilet, and cooking facilities. A dwelling unit does not include property used solely as a hotel, motel, inn, or similar establishment.

Property is used solely as a hotel, motel, inn, or similar establishment if it is regularly available for occupancy by paying customers and is not used by an owner as a home during the year.

Example.

You rent a room in your home that is always available for short-term occupancy by paying customers. You do not use the room yourself, and you allow only paying customers to use the room. The room is used solely as a hotel, motel, inn, or similar establishment and is not a dwelling unit.

Dwelling Unit Used as Home

The tax treatment of rental income and expenses for a dwelling unit that you also use for personal purposes depends on whether you use it as a home. (See How To Figure Rental Income and Deductions, later.)

You use a dwelling unit as a home during the tax year if you use it for personal purposes more than the greater of:

14 days, or
10% of the total days it is rented to others at a fair rental price.

See Figuring Days of Personal Use, later.

If a dwelling unit is used for personal purposes on a day it is rented at a fair rental price, do not count that day as a day of rental use in applying (2) above. Instead, count it as a day of personal use in applying both (1) and (2) above. This rule does not apply when dividing expenses between rental and personal use.

Fair rental price. A fair rental price for your property generally is an amount that a person who is not related to you would be willing to pay. The rent you charge is not a fair rental price if it is substantially less than the rents charged for other properties that are similar to your property.

Examples

The following examples show how to determine whether you used your rental property as a home.

Example 1.

You converted the basement of your home into an apartment with a bedroom, a bathroom, and a small kitchen. You rented the basement apartment at a fair rental price to college students during the regular school year. You rented to them on a 9-month lease (273 days). You figured 10% of the total days rented to others at a fair rental price is 27 days.

During June (30 days), your brother stayed with you and lived in the basement apartment rent free.

Your basement apartment was used as a home because you used it for personal purposes for 30 days. Rent-free use by your brother is considered personal use. Your personal use (30 days) is more than the greater of 14 days or 10% of the total days it was rented (27 days).

Example 2.

You rented the guest bedroom in your home at a fair rental price during the local college's homecoming, commencement, and football weekends (a total of 27 days). Your sister-in-law stayed in the room, rent free, for the last 3 weeks (21 days) in July. You figured 10% of the total days rented to others at a fair rental price is 3 days.

The room was used as a home because you used it for personal purposes for 21 days. That is more than the greater of 14 days or 10% of the 27 days it was rented (3 days).

Example 3.

You own a condominium apartment in a resort area. You rented it at a fair rental price for a total of 170 days during the year. For 12 of those days, the tenant was not able to use the apartment and allowed you to use it even though you did not refund any of the rent. Your family actually used the apartment for 10 of those days. Therefore, the apartment is treated as having been rented for 160 (170 - 10) days. You figure 10% of the total days rented to others at a fair rental price is 16 days. Your family also used the apartment for 7 other days during the year.

You used the apartment as a home because you used it for personal purposes for 17 days. That is more than the greater of 14 days or 10% of the 160 days it was rented (16 days).

Use As Main Home Before or After Renting

For purposes of determining whether a dwelling unit was used as a home, you may not have to count days you used the property as your main home before or after renting it or offering it for rent as days of personal use if:

You rented or tried to rent the property for 12 or more consecutive months.
You rented or tried to rent the property for a period of less than 12 consecutive months and the period ended because you sold or exchanged the property.

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

Figuring Days of Personal Use

A day of personal use of a dwelling unit is any day that the unit is used by any of the following persons.

You or any other person who has an interest in it, unless you rent it to another owner as his or her main home under a shared equity financing agreement (defined later).
A member of your family or a member of the family of any other person who has an interest in it, unless the family member uses the dwelling unit as his or her main home and pays a fair rental price. Family includes only brothers and sisters, half-brothers and half-sisters, spouses, ancestors (parents, grandparents, etc.) and lineal descendants (children, grandchildren, etc.).
Anyone under an arrangement that lets you use some other dwelling unit.
Anyone at less than a fair rental price.

Main home. If the other person or member of the family in (1) or (2) above has more than one home, his or her main home is ordinarily the one he or she lived in most of the time.

Shared equity financing agreement. This is an agreement under which two or more persons acquire undivided interests for more than 50 years in an entire dwelling unit, including the land, and one or more of the co-owners is entitled to occupy the unit as his or her main home upon payment of rent to the other co-owner or owners.

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

You donate the use of the unit to a charitable organization,
The organization sells the use of the unit at a fund-raising event, and
The “purchaser” uses the unit.

Examples

The following examples show how to determine days of personal use.

Example 1.

You and your neighbor are co-owners of a condominium at the beach. You rent the unit to vacationers whenever possible. The unit is not used as a main home by anyone. Your neighbor uses the unit for 2 weeks every year.

Because your neighbor has an interest in the unit, both of you are considered to have used the unit for personal purposes during those 2 weeks.

Example 2.

You and your neighbors are co-owners of a house under a shared equity financing agreement. Your neighbors live in the house and pay you a fair rental price.

Even though your neighbors have an interest in the house, the days your neighbors live there are not counted as days of personal use by you. This is because your neighbors rent the house as their main home under a shared equity financing agreement.

Example 3.

You own a rental property that you rent to your son. Your son has no interest in this property. He uses it as his main home. He pays you a fair rental price for the property.

Your son's use of the property is not personal use by you because your son is using it as his main home, he has no interest in the property, and he is paying you a fair rental price.

Example 4.

You rent your beach house to Joshua. Joshua rents his house in the mountains to you. You each pay a fair rental price.

You are using your house for personal purposes on the days that Joshua uses it because your house is used by Joshua under an arrangement that allows you to use his house.

Days Used for Repairs and Maintenance

Any day that you spend working substantially full time repairing and maintaining your property is not counted as a day of personal use. Do not count such a day as a day of personal use even if family members use the property for recreational purposes on the same day.

How To Divide Expenses

If you use a dwelling unit for both rental and personal purposes, divide your expenses between the rental use and the personal use based on the number of days used for each purpose. You can deduct expenses for the rental use of the unit under the rules explained in How To Figure Rental Income and Deductions, later.

When dividing your expenses follow these rules.

Any day that the unit is rented at a fair rental price is a day of rental use even if you used the unit for personal purposes that day. This rule does not apply when determining whether you used the unit as a home.
Any day that the unit is available for rent but not actually rented is not a day of rental use.

Example.

Your beach cottage was available for rent from June 1 through August 31 (92 days). Your family uses the cottage during the last 2 weeks in May (14 days). You were unable to find a renter for the first week in August (7 days). The person who rented the cottage for July allowed you to use it over a weekend (2 days) without any reduction in or refund of rent. The cottage was not used at all before May 17 or after August 31.

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

The cottage was used for rental a total of 85 days (92 - 7). The days it was available for rent but not rented (7 days) are not days of rental use. The July weekend (2 days) you used it is rental use because you received a fair rental price for the weekend.
You used the cottage for personal purposes for 14 days (the last 2 weeks in May).
The total use of the cottage was 99 days (14 days personal use + 85 days rental use).
Your rental expenses are 85/99 (86%) of the cottage expenses.

When determining whether you used the cottage as a home, the July weekend (2 days) you used it is personal use even though you received a fair rental price for the weekend. Therefore, you had 16 days of personal use and 83 days of rental use for this purpose. Because you used the cottage for personal purposes more than 14 days and more than 10% of the days of rental use (8 days), you used it as a home. If you have a net loss, you may not be able to deduct all of the rental expenses. See Property Used as a Home in the following discussion.

How To Figure Rental Income and Deductions

How you figure your rental income and deductions depends on whether you used the dwelling unit as a home (see Dwelling Unit Used as Home, earlier) and, if you used it as a home, how many days the property was rented at a fair rental price.

Property Not Used as a Home

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

Your deductible rental expenses can be more than your gross rental income. However, see Limits on Rental Losses, later.

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Worksheet 10-1 Worksheet for figuring limit on rental deductions

Property Used as a Home

If you use a dwelling unit as a home during the year (see Dwelling Unit Used as Home, earlier), how you figure your rental income and deductions depends on how many days the unit was rented at a fair rental price.

Rented fewer than 15 days. If you use a dwelling unit as a home and you rent it fewer than 15 days during the year, do not include any rental income in your income. Also, you cannot deduct any expenses as rental expenses.

Rented 15 days or more. If you use a dwelling unit as a home and rent it 15 days or more during the year, you include all your rental income in your income. See How To Report Rental Income and Expenses, later. If you had a net profit from the rental property for the year (that is, if your rental income is more than the total of your rental expenses, including depreciation), deduct all of your rental expenses. However, if you had a net loss, your deduction for certain rental expenses is limited.

Use Worksheet 10-1 to figure your deductible expenses.

Depreciation

You recover your cost in income producing property through yearly tax deductions. You do this by depreciating the property; that is, by deducting some of your cost on your tax return each year.

Three basic factors determine how much depreciation you can deduct. They are: (1) your basis in the property, (2) the recovery period for the property, and (3) the depreciation method used. You cannot simply deduct your mortgage or principal payments, or the cost of furniture, fixtures and equipment, as an expense.

You can deduct depreciation only on the part of your property used for rental purposes. Depreciation reduces your basis for figuring gain or loss on a later sale or exchange.

You may have to use Form 4562 to figure and report your depreciation. See How To Report Rental Income and Expenses, later.

Claiming the correct amount of depreciation. You should claim the correct amount of depreciation each tax year. Even if you did not claim depreciation that you were entitled to deduct, you must still reduce your basis in the property by the full amount of depreciation that you could have deducted. If you did not deduct the correct amount of depreciation for property in any year, you may be able to make a correction for that year by filing Form 1040X, Amended U.S Individual Income Tax Return. If you are not allowed to make the correction on an amended return, you can change your accounting method to claim the correct amount of depreciation. See Claiming the correct amount of depreciation in Publication 527 for more information.

Changing your accounting method to deduct unclaimed depreciation. To change your accounting method, you must file Form 3115, Application for Change in Accounting Method, to get the consent of the IRS. In some instances, you can receive automatic consent. For more information, see chapter 1 of Publication 946.

Land. You can never depreciate the cost of land because land does not wear out, become obsolete, or get used up. The costs of clearing, grading, planting, and landscaping are usually all part of the cost of land and cannot be depreciated.

Depreciation Methods

There are three ways to figure depreciation. The depreciation method you use depends on the type of property and when it was placed in service. For property used in rental activities you use one of the following.

MACRS (Modified Accelerated Cost Recovery System) for property placed in service after 1986.
ACRS (Accelerated Cost Recovery System) for property placed in service after 1980 but before 1987.
Useful lives and either straight line or an accelerated method of depreciation, such as the declining balance method, for property placed in service before 1981.

This chapter discusses MACRS only. If you need more information about depreciating property placed in service before 1987, see Publication 534.

If you placed property in service before 2004, continue to use the same method of figuring depreciation that you used in the past.

Section 179 election. You cannot claim the section 179 deduction for property held to produce rental income. See chapter 2 of Publication 946.

No deduction greater than basis. The total of all your yearly depreciation deductions cannot be more than the cost or other basis of the property. For this purpose, your yearly depreciation deductions include any depreciation that you were allowed to claim, even if you did not claim it.

Cooperative apartments. If you are a tenant-stockholder in a cooperative housing corporation and rent your cooperative apartment to others, you can deduct depreciation for your stock in the corporation. Your depreciation deduction is your share of the corporation's depreciation. See Cooperative apartments in Publication 527 for information on how to figure your depreciation deduction.

Special Depreciation Allowance

You can claim a special depreciation allowance (in addition to your regular MACRS depreciation deduction) for qualified property you placed in service in 2004. The allowance is 50% of the property's depreciable basis. You figure the special depreciation allowance before you figure your regular MACRS deduction.

Electing to claim a lower or no special depreciation allowance. You can elect, for any class of property, to deduct the 30% (instead of 50%) special allowance for all property in such class placed in service during the tax year. Or, you can elect not to deduct any special allowance for all property in such class placed in service during the tax year.

Qualified property. To qualify for the special depreciation allowance, your property must meet the following requirements.

It must be new property that is depreciated under MACRS with a recovery period of 20 years or less.
It must meet the following tests.
1. Acquisition date test.
2. Placed-in-service date test.
3. Original use test.

Acquisition date test. Generally, you must have acquired the property after September 10, 2001 (after May 5, 2003, to be eligible for the 50% special depreciation allowance).

Placed-in-service date test. Generally, the property must be placed in service for use in your trade or business or for the production of income after September 10, 2001 (after May 5, 2003, to be eligible for the 50% special depreciation allowance), and before January 1, 2005.

Original use test. The original use of the property must have begun with you after September 10, 2001 (after May 5, 2003, to be eligible for the 50% special depreciation allowance). “Original use” means the first use to which the property is put, whether or not by you.

Example.

Dave bought and placed in service a new refrigerator ($700) for one of his residential rental properties in 2004. Dave notes that the refrigerator has a 5-year recovery period (see Table 10-1). Dave's refrigerator is qualifying property and he claims the 50% special depreciation allowance.

Dave determines the total depreciable basis of the property to be $700. Next, he multiplies this amount by 50% to figure his special depreciation allowance deduction of $350 ($700 × 50%). This leaves an adjusted basis of $350 ($700 - $350), which he will use to figure his MACRS deduction.

For more information, see Special Depreciation Allowance in Publication 946.

MACRS

Most business and investment property placed in service after 1986 is depreciated using MACRS.

MACRS consists of two systems that determine how you depreciate your property—the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). GDS is used to figure your depreciation deduction for property used in most rental activities, unless you elect ADS.

To figure your MACRS deduction, you need to know the following information about your property:

Its recovery period,
Its placed-in-service date, and
Its depreciable basis.

Personal home changed to rental use. You must use MACRS to figure the depreciation on property you used as your home and changed to rental property in 2004.

Excluded property. You cannot use MACRS for certain personal property placed in service in your rental property in 2004 if it had been previously placed in service before MACRS became effective.

In addition, you may elect to exclude certain property from the application of MACRS. See Publication 946 for more information.

Recovery Periods Under GDS

Each item of property that can be depreciated is assigned to a property class. The recovery period of the property depends on the class the property is in. Under GDS, the recovery period of an asset is generally the same as its property class. The property classes under GDS are:

3-year property,
5-year property,
7-year property,
10-year property,
15-year property,
20-year property,
Nonresidential real property, and
Residential rental property.

Recovery periods for property used in rental activities are shown in Table 10-1.

The class to which property is assigned is determined by its class life. Class lives and recovery periods for most assets are listed in Appendix B in Publication 946.

Additions or improvements to property. Treat depreciable additions or improvements you make to any property as separate property items for depreciation purposes. The recovery period for an addition or improvement to property begins on the later of:

The date the addition or improvement is placed in service, or
The date the property to which the addition or improvement was made is placed in service.

The property class and recovery period of the addition or improvement is the one that would apply to the original property if it were placed in service at the same time as the addition or improvement.

Example.

You own a residential rental house that you have been renting since 1986 and that you are depreciating under ACRS. You put an addition onto the house and you placed it in service in 2004. You must use MACRS for the addition. Under GDS, the addition is depreciated as residential rental property over 27.5 years.

Placed-in-Service Date

You can begin to depreciate property when you place it in service in your trade or business or for the production of income. Property is considered placed in service in a rental activity when it is ready and available for a specific use in that activity.

Depreciable Basis

To deduct the proper amount of depreciation each year, you must first determine your basis in the property you intend to depreciate. The basis used for figuring depreciation is your original basis in the property increased by any additions or improvements made to the property. Your original basis is usually your cost. However, if you acquire the property in some other way, such as by inheriting it, getting it as a gift, or building it yourself, you may have to figure your original basis in another way. Other adjustments could also affect your basis. See chapter 14.

Conventions

Under MACRS, conventions establish when the recovery period begins and ends. The convention you use determines the number of months for which you can claim depreciation in the year you place property in service and in the year you dispose of the property.

Mid-month convention. A mid-month convention is used for all residential rental property and nonresidential real property. Under this convention, you treat all property placed in service, or disposed of, during any month as placed in service, or disposed of, at the midpoint of that month.

Mid-quarter convention. A mid-quarter convention must be used if the mid-month convention does not apply and the total depreciable basis of MACRS property you placed in service in the last 3 months of a tax year (excluding nonresidential real property, residential rental property, and property placed in service and disposed of in the same year) is more than 40% of the total basis of all such property you place in service during the tax year.

Half-year convention. The half-year convention is used if neither the mid-quarter convention nor the mid-month convention applies. Under this convention, you treat all property placed in service, or disposed of, during a tax year as placed in service, or disposed of, at the midpoint of that tax year.

If this convention applies, you deduct a half-year of depreciation for the first year and the last year that you depreciate the property. You deduct a full year of depreciation for any other year during the recovery period.

Table 10-1. MACRS Recovery Periods for Property Used in Rental Activities

	MACRS Recovery Period
Type of Property	General Depreciation System	Alternative Depreciation System
Computers and their peripheral equipment	5 years	5 years
Office machinery, such as: Typewriters Calculators Copiers	5 years	6 years
Automobiles	5 years	5 years
Light trucks	5 years	5 years
Appliances, such as: Stoves Refrigerators	5 years	9 years
Carpets	5 years	9 years
Furniture used in rental property	5 years	9 years
Office furniture and equipment, such as: Desks Files	7 years	10 years
Any property that does not have a class life and that has not been designated by law as being in any other class	7 years	12 years
Roads	15 years	20 years
Shrubbery	15 years	20 years
Fences	15 years	20 years
Residential rental property (buildings or structures) and structural components such as furnaces, water pipes, venting, etc.,	27.5 years	40 years
Additions and improvements, such as a new roof	The same recovery period as that of the property to which the addition or improvement is made, determined as if the property were placed in service at the same time as the addition or improvement.

Under this convention, you treat all property placed in service, or disposed of, during any quarter of a tax year as placed in service, or disposed of, at the midpoint of the quarter.

Example.

During the tax year, Jordan Gregory purchased the following items to use in his rental property. He elects not to claim the special depreciation allowance, discussed earlier.

A dishwasher for $400, that he placed in service in January.
Used furniture for $100, that he placed in service in September.
A refrigerator for $500, that he placed in service in October.

Jordan uses the calendar year as his tax year. The total basis of all property placed in service in that year is $1,000. The $500 basis of the refrigerator placed in service during the last 3 months of his tax year exceeds $400 (40% × $1,000). Jordan must use the mid-quarter convention instead of the half-year convention for all three items.

MACRS Depreciation Under GDS

You can figure your MACRS depreciation deduction under GDS in one of two ways. The deduction is substantially the same both ways. (The difference, if any, is slight.) You can either:

Use the percentage from the optional MACRS tables, see Table 10-2, or
Actually figure the deduction using the depreciation method and convention that apply over the recovery period of the property.

Publication 946 discusses computing depreciation using the proper method and convention.

Table 10-2. Optional MACRS Tables Table 10-2-A. MACRS 5-Year property

	Half-year convention	Mid-quarter convention
Year		First quarter	Second quarter	Third quarter	Fourth quarter
1 2 3 4 5 6	20.00% 32.00 19.20 11.52 11.52 5.76	35.00% 26.00 15.60 11.01 11.01 1.38	25.00% 30.00 18.00 11.37 11.37 4.26	15.00% 34.00 20.40 12.24 11.30 7.06	5.00% 38.00 22.80 13.68 10.94 9.58

Table 10-2-B. MACRS 7-Year property

	Half-year convention	Mid-quarter convention
Year		First quarter	Second quarter	Third quarter	Fourth quarter
1