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From resident to landlord: depreciating a former personal residence: the combination of an economic recession, a mortgage crisis and an aging population has led to a large number of homeowners recently becoming landlords.

Whether due to a relocation for work, a transfer to an assisted living facility or purely for economic considerations, homeowners who are unable to sell a former primary residence have turned to renting it. As property managers, you may have experienced an influx of first-time landlords entering the rental market or received inquiries about doing so. When converting a former personal residence to rental property there are some significant tax effects that should be assessed. One of the most commonly misunderstood concepts is that of depreciation. As their current or potential property manager, your basic understanding of depreciation can be useful in helping owners achieve their rental objectives while avoiding missteps.

Depreciation in General

Depreciation is a deductible expense, based on the notion that everyday wear and tear on a property should be recognized ratably over the expected useful life of that property. Depreciation is a significant expense for your clients because it is a non-cash deduction. Unlike mortgage interest, property taxes or repairs, depreciation expense is available without any cash outlay. It enables the landlord to generate a positive cash flow on their property without necessarily generating tax-able income.

Amount to Depreciate

Since land is presumably not subject to normal wear and tear or obsolescence, only the building and personal property components of the rental property are subject to depreciation. Therefore, when a residence is converted to rental property, a distinction must be made between the depreciable amount of building and the non-depreciable amount of land. If a $100,000 property has 50 percent of its cost attributed to the land, only $50,000 will be subject to depreciation expense.

The amount to be depreciated is not necessarily the amount that your client paid for the property, but the lesser of the property's cost or its fair market value at the time of conversion. This is significant for multiple reasons. In today's declining real estate market, many homes are worth much less than the amount paid for them. Rather than depreciating the higher purchase amount, the expense is calculated based on the lower fair market value. This also serves to prevent homeowners with declining property values from converting properties to rentals in order to deduct tax losses. To illustrate the effects of the limitation to tax basis in a declining real estate market, consider the following example.

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After relocating from Boston to New York, Charlie decided to rent his former residence through a property manager. He bought the house ten years ago for $1 million, but it recently appraised for only $500,000. Twenty percent of the property's value ($100,000) is attributed to the land and 80 percent is attributed to the building and improvements. When Charlie places the property in ser-vice for rent he will begin depreciating it over 27.5 years. Rather than depreciating $800,000, or 80 percent of $1 million, Charlie must use the lower fair market value as his depreciable base, or $400,000. This gives him a depreciation expense of $14,545 per year rather than $29,091 per year had he been able to use his actual cost. Clients often overlook this rule and assume they can deduct depreciation based on the higher original cost of the property.

Consequences of a Sale

Depreciation reduces the tax basis of the property, which ultimately impacts the amount of tax gain or loss realized when the property is sold. It is a deductible expense while the property is held, based on the premise that the property is declining in value over time due to wear and tear, usage or obsolescence. Accordingly, if the property is eventually sold for more than its depreciated basis and resulting in a gain, then it had not truly been losing value while the depreciation expense was being taken. To make up for the benefit received from this artificial deduction, tax law requires the seller pays tax at a maximum rate of 25 percent on any gain attributed to real property depreciation. For example, suppose Charlie bought a residential rental property in New York for $500,000 (all attributed to the building), depreciated it for two years, and then sold it for $500,000.
The following table shows how Charlie would calculate his gain:

Purchase Price           $500,000

Less: Depreciation      -(36,364)

Adjusted Basis            463,636

Sale Proceeds            $500,000

Less: Adjusted Basis   -(463,636)

Taxable Gain               36,364

While depreciation provides a tax benefit during the period in
which the property is in use, it can create taxable income at
the time of sale.


When and For How Long?

The IRS has established that residential real property is depreciated over 27.5 years beginning with the date the property is placed into service as business or investment property. But this doesn't mean that a house built in 1984 is fully depreciated as soon as it is converted to a rental in 2012. Instead, depreciation will be taken over the next 27.5 years, beginning in 2012, until the building is actually more than 50 years old. The date it was originally purchased or first used as your client's residence is irrelevant to the depreciation calculation. While residential property depreciates over 27.5 years and land cannot be depreciated, other components of the rental property--if properly identified--can be expensed more rapidly. Appliances, carpet and furniture all have much shorter depreciation periods than the building, but are also subject to recapture of the depreciation when the items are sold. It is important to distinguish the building or improvement components of the property from the land in order to determine the amount subject to depreciation. Encourage clients converting prior personal residences to rental property to obtain a qualified appraisal at the time of conversion to determine the value of the property and possibly the break-out of its components. Other sources that can be used for the allocation are local property tax assessments or an insurance estimate of replacement cost. Overall, the value used and the allocation should be reasonable and supported by documented facts.

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Homeowners converting their former residences to rental property often miscalculate their allowable depreciation expense or tail to realize the tax benefit of the expense Likewise, they are often unprepared for the tax consequences upon the sale of property that has been depreciated. Gain is calculated on the depreciation that was actually taken as well depreciation that could have been taken but was overlooked. As you are faced with a rising base of these first-time landlords, be sure to inform them about the pros and cons of depreciating their converted property.

BY DANIEL ROWE, CPA

DANIEL ROWE, CPA, (DROWE@DDFCPAS.COM) IS TAX MANAGER FOR DEEMER DANA & FROEHLE LLP IN SAVANNAH, GA.

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Comment:From resident to landlord: depreciating a former personal residence: the combination of an economic recession, a mortgage crisis and an aging population has led to a large number of homeowners recently becoming landlords.
Author:Rowe, Daniel
Publication:Journal of Property Management
Geographic Code:1USA
Date:Sep 1, 2012
Words:1119
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