9.5 Depreciation on Converting a Home to Rental Property

When you convert your residence to rental property, you may depreciate the building. You figure depreciation on the lower of:

• Fair market value of the building at the time you convert it to rental property; or
• Adjusted basis. This is your original cost for the building, exclusive of land, plus permanent improvements and other capital costs, and minus items that represent a return of your cost, such as casualty or theft loss deductions claimed on prior tax returns.

You claim MACRS depreciation based on a 27½-year recovery period, which extends to 28 or 29 years due to the mid-month convention. The specific rate for the year of conversion is the rate for the month in which the property is ready for tenants. For example, you move out of your home in May and make some minor repairs. You advertise the house for rent in June. Depreciation starts in June because that is when the home is ready for rental, even if you do not actually obtain a tenant until a later month. Under a mid-month convention, the house is treated as placed in service during the middle of the month. This means that one-half of a full month’s depreciation is allowed for that month. In Table 9-1, the monthly depreciation rates for the year the property is placed in service and later years are shown. The table incorporates the mid-month convention.

Planning Reminder

Obtain Appraisal

Have an appraiser estimate the fair market value of the house when it is rented. The appraisal will help support your basis for depreciation or a loss deduction on a sale if your return is examined.

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Depreciating a rented cooperative apartment.

If you rent out a co-op apartment, you may deduct your share of the total depreciation claimed by the cooperative corporation. The method for computing your share depends on whether you bought your co-op shares as part of the first offering. If you did, follow these steps: (1) Ask the co-op corporation officials for the total real estate depreciation deduction of the corporation, not counting depreciation for office space that cannot be lived in by tenant-shareholders. (2) Multiply Step 1 by the following fraction: number of your co-op shares divided by total shares outstanding. The result is your share of the co-op’s depreciation, but you may not deduct more than your adjusted basis.

The computation is more complicated if you bought your co-op shares after the first offering. You must compute your depreciable basis as follows: Increase your cost for the co-op shares by your share of the co-op’s total mortgage. Reduce this amount by your share of the value of the co-op’s land and your share of the commercial space not available for occupancy by tenant-stockholders. Your “share” of the co-op’s mortgage, land value, or commercial space is the co-op’s total amount for such items multiplied by the fraction in Step 2 above, that is, the number of your shares divided by the total shares outstanding. After computing your depreciable basis, multiply that basis by the depreciation percentage for the month your apartment is ready for rental.

Basis to use when you sell a rented residence.

For purposes of figuring gain, you use adjusted basis at the time of the conversion, plus subsequent capital improvements, and minus depreciation and casualty loss deductions. For purposes of figuring loss, you use the lower of adjusted basis and fair market value at the time of the conversion, plus subsequent improvements and minus depreciation and casualty losses. You may have neither gain nor loss to report; this would happen if you figure a loss when using the above basis rule for gains and you figure a gain when using the basis rule for losses.

Depreciation on a vacant residence.

If you move from your house before it is sold, you generally may not deduct depreciation on the vacant residence while it is held for sale. The IRS will not allow the deduction, and, according to the Tax Court, a deduction is possible only if you can show that you held the house expecting to make a profit on an increase in value over and above the value of the house when you moved from it. That is, you held the house for sale on the expectation of profiting on a future increase in value after abandoning the house as a residence.