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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, discussed later, that may be rental income.

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 in 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.

Example 1.

Your tenant pays the water and sewage bill for your rental property and deducts it from the normal rent payment. Under the terms of the lease, your tenant does not have to pay this bill. Include the utility bill paid by the tenant and any amount received as a rent payment in your rental income. You can deduct the utility payment made by your tenant as a rental expense.

Example 2.

While you are out of town, the furnace in your rental property stops working. Your tenant pays for the necessary repairs and deducts the repair bill from the rent payment. Include the repair bill paid by the tenant and any amount received as a rent payment in your rental income. You can deduct the repair payment made by your tenant as a rental expense.

Example.

Your tenant is a painter. He offers to paint your rental property instead of paying 2 months' rent. You accept his offer.

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

Lease with option to buy. If the rental agreement gives your tenant the right to buy your rental property, the payments you receive under the agreement are generally rental income. If your tenant exercises the right to buy the property, the payments you receive for the period after the date of sale are considered part of the selling price.

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 section discusses 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 a condominium or cooperative apartment, 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 under Depreciation.

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.

Uncollected rent. If you are a cash basis taxpayer, you do not report uncollected rent. Because you do not include it in your income, you cannot deduct it. If you use an accrual method, you report income when you earn it. If you are unable to collect the rent, you may be able to deduct it as a business bad debt. See chapter 10 of Publication 535 for more information about business bad debts.

Table 1. Examples of Improvements

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. Table 1 shows examples of many improvements. 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

In addition to depreciation and the cost of repairs, you can deduct the following expenses from your rental income.

• Advertising.

• Cleaning and maintenance.

• Utilities.

• Insurance.

• Taxes.

• Interest.

• Points.

• Commissions.

• Tax return preparation fees.

• Travel expenses.

• Rental payments.

• Local transportation expenses.

Some of these expenses are 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.

Interest expense. You can deduct mortgage interest you pay on your rental property. Chapter 4 of Publication 535 explains mortgage interest in detail.

Expenses paid to obtain a mortgage. Certain expenses you pay to obtain a mortgage on your rental property cannot be deducted as interest. These expenses, which include mortgage commissions, abstract fees, and recording fees, are capital expenses. However, you can amortize them over the life of the mortgage.

Form 1098. If you paid $600 or more of mortgage interest on your rental property to any one person, you should receive a Form 1098, Mortgage Interest Statement, or similar statement showing the interest you paid for the year. If you and at least one other person (other than your spouse if you file a joint return) were liable for, and paid interest on, the mortgage, and the other person received the Form 1098, report your share of the interest on Schedule E (Form 1040), line 13. Attach a statement to your return showing the name and address of the other person. In the left margin of Schedule E, next to line 13, enter “See attached.”

Points. The term “points” is often used to describe some of the charges paid by a borrower to take out a loan or a mortgage. These charges are also called loan origination fees, maximum loan charges, or premium charges. If any of these charges (points) are solely for the use of money, they are interest. Points paid when you take out a loan or mortgage result in original issue discount (OID). In general, the points (OID) are deductible as interest unless they must be capitalized. How you figure the amount of points (OID) you can deduct each year depends on whether or not your total OID, including the OID resulting from the points, is insignificant or de minimis. If the OID is not de minimis, you must use the constant-yield method to figure how much you can deduct.

De minimis OID. The OID is de minimis if it is less than one-fourth of 1% (.0025) of the stated redemption price at maturity multiplied by the number of full years from the date of original issue to maturity (the term of the loan). If the OID is de minimis, you can choose one of the following ways to figure the amount you can deduct each year.

1. On a constant-yield basis over the term of the loan.

2. On a straight line basis over the term of the loan.

3. In proportion to stated interest payments.

4. In its entirety at maturity of the loan.

Example of de minimis amount.

On January 1, 2006, you took out a loan for $100,000. The loan matures on January 1, 2016 (a 10-year term), and the stated principal amount of the loan ($100,000) is payable on that date. An interest payment of $10,000 is payable to the bank on January 2 of each year, beginning on January 2, 2007. When the loan was made, you paid $1,500 in points to the bank. The points reduced the issue price of the loan from $100,000 to $98,500, resulting in $1,500 of OID. You determine that the points (OID) you paid are de minimis based on the following computation.

The points (OID) you paid ($1,500) are less than the de minimis amount. Therefore, you have de minimis OID and you can choose one of the four ways discussed earlier to figure the amount you can deduct each year. Under the straight line method, you can deduct $150 each year for 10 years.

1. Determine the issue price of the loan. Generally, this equals the proceeds of the loan. If you paid points on the loan, the issue price generally is the difference between the proceeds and the points.

2. Multiply the result in (1) by the yield to maturity.

3. Subtract any qualified stated interest payments from the result in (2). This is the OID you can deduct in the first year.

Example of constant yield.

The facts are the same as in the previous example. The yield to maturity on your loan is 10.2467%, compounded annually.

You figure the amount of points (OID) you can deduct in 2006 as follows.

You figure the deduction for 2007 as follows.

Loan or mortgage ends. If your loan or mortgage ends, you may be able to deduct any remaining points (OID) in the tax year in which the loan or mortgage ends. A loan or mortgage may end due to a refinancing, prepayment, foreclosure, or similar event. However, if the refinancing is with the same lender, the remaining points (OID) generally are not deductible in the year in which the refinancing occurs, but may be deductible over the term of the new mortgage or loan.

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. You cannot deduct the cost of traveling away from home if the primary purpose of the trip was the improvement of your property. You recover the cost of improvements by taking depreciation. For information on travel expenses, see chapter 1 of Publication 463. To deduct travel expenses, you must keep records that follow the rules in chapter 5 of Publication 463.

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 2006, the standard mileage rate is 44½ cents a mile for all business miles. For more information, see chapter 4 of Publication 463. To deduct car expenses under either method, you must keep records that follow the rules in chapter 5 of Publication 463. 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 tax return preparation fees you paid to prepare Schedule E (Form 1040), Part I. For example, on your 2006 Schedule E you can deduct fees paid in 2006 to prepare Part I of your 2005 Schedule E. You can also deduct, as a rental expense, any expense (other than federal taxes and penalties) you paid to resolve a tax underpayment related to your rental activities.

Condominiums and Cooperatives

If you rent out a condominium or a cooperative apartment, special rules apply. Condominiums are treated differently from cooperatives.

Condominium

If you own a condominium, you own a dwelling unit in a multi-unit building. You also own a share of the common elements of the structure, such as land, lobbies, elevators, and service areas. You and the other condominium owners may pay dues or assessments to a special corporation that is organized to take care of the common elements.

If you rent your condominium to others, you can deduct:

• Depreciation,

• Repairs,

• Upkeep,

• Dues,

• Interest and taxes, and

• Assessments for the care of the common parts of the structure.

You cannot deduct special assessments you pay to a condominium management corporation for improvements. But you may be able to recover your share of the cost of any improvement by taking depreciation.

Cooperative

If you have a cooperative apartment that you rent to others, you can usually deduct, as a rental expense, all the maintenance fees you pay to the cooperative housing corporation. However, you cannot deduct a payment earmarked for a capital asset or improvement, or otherwise charged to the corporation's capital account. For example, you cannot deduct a payment used to pave a community parking lot, install a new roof, or pay the principal of the corporation's mortgage. You must add the payment to the basis of your stock in the corporation.

Treat as a capital cost the amount you were assessed for capital items. This cannot be more than the amount by which your payments to the corporation exceeded your share of the corporation's mortgage interest and real estate taxes.

Your share of interest and taxes is the amount the corporation elected to allocate to you, if it reasonably reflects those expenses for your apartment. Otherwise, figure your share in the following way.

1. Divide the number of your shares of stock by the total number of shares outstanding, including any shares held by the corporation.

2. Multiply the corporation's deductible interest 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 paid to the cooperative housing corporation, you can deduct your direct payments for repairs, upkeep, and other rental expenses, including interest paid on a loan used to buy your stock in the corporation. The depreciation deduction allowed for cooperative apartments is discussed later.

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 Schedule A (Form 1040) 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 line 22 of Schedule A (Form 1040). You can deduct these expenses only if they, together with certain other miscellaneous itemized deductions, total more than 2% of your adjusted gross income.

Postponing decision. If your rental income is more than your rental expenses for at least 3 years out of a period of 5 consecutive years, you are presumed to be renting your property to make a profit. You may choose to postpone the decision of whether the rental is for profit by filing Form 5213. See Publication 535 for more information.

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 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 out 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.

When figuring depreciation, treat the property as placed in service on June 1.

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 tenant's 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.

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 of floor space. You can deduct as a rental expense 10% of any expense that must be divided between rental use and personal use. If your heating bill for the year for the entire house was $600, $60 ($600 × 10%) is a rental expense. The balance, $540, is a personal expense that you cannot deduct.

Personal Use of Dwelling Unit (Including Vacation Home)

If you have any personal use of a dwelling unit (defined later) (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 a 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 the dwelling unit is not considered a dwelling unit used as a home, you can deduct rental expenses that are more than your 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:

1. 14 days, or

2. 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.

• 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?

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 brothers 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 brothers 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 these 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. Do not count them 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.

Example 1.

On February 28, you moved out of the house you had lived in for 6 years because you accepted a job in another town. You rent your house at a fair rental price from March 15 of that year to May 14 of the next year (14 months). On the following June 1, you move back into your old house.

The days you used the house as your main home from January 1 to February 28 and from June 1 to December 31 of the next year are not counted as days of personal use.

Example 2.

On January 31, you moved out of the condominium where you had lived for 3 years. You offered it for rent at a fair rental price beginning on February 1. You were unable to rent it until April. On September 15, you sold the condominium.

The days you used the condominium as your main home from January 1 to January 31 are not counted as days of personal use when determining whether you used it as a home.

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.

1. 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). However, see Use as Main Home Before or After Renting under Dwelling Unit Used As Home, earlier.

2. 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.).

3. Anyone under an arrangement that lets you use some other dwelling unit.

4. 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 Rosa. Rosa rents her 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 Rosa uses it because your house is used by Rosa under an arrangement that allows you to use her house.

Example 5.

You rent an apartment to your mother at less than a fair rental price. You are using the apartment for personal purposes on the days that your mother rents it because you rent it for less than a fair rental price.

Days Used for Repairs and Maintenance

Any day that you spend working substantially full time repairing and maintaining (not improving) 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.

Example.

You own a cabin in the mountains that you rent during the summer. You spend 3 days at the cabin each May, working full time to repair anything that was damaged over the winter and get the cabin ready for the summer. You also spend 3 days each September, working full time to repair any damage done by renters and getting the cabin ready for the winter.

These 6 days do not count as days of personal use even if your family uses the cabin while you are repairing it.

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.

Property Used as a Home

If you use a dwelling unit as a home during the year, 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.

Limit on deductions. If your rental expenses are more than your rental income, you cannot use the excess expenses to offset income from other sources. The excess can be carried forward to the next year and treated as rental expenses for the same property. Any expenses carried forward to next year will be subject to any limits that apply next year. You can deduct the expenses carried over to a year only up to the amount of your rental income for that year, even if you do not use the property as your home for that year.

Depreciation

You recover the cost of income producing property through yearly tax deductions. You do this by depreciating the property; that is, by deducting some of the cost on the 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. Also see Publication 946.

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. See Decreases to basis, later, for more information. 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 Changing your accounting method, later.

Filing an amended return. You can file an amended return to correct the amount of depreciation claimed for any property in any of the following situations.

• You claimed the incorrect amount because of a mathematical error made in any year.

• You claimed the incorrect amount because of a posting error made in any year.

• You have not adopted a method of accounting for the property.

• 3 years from the date you filed your original return for the year in which you did not deduct the correct amount. (A return filed early is considered filed on the due date.)

• 2 years from the time you paid your tax for that year.

What Property Can be Depreciated

You can depreciate your property if it meets all the following requirements.

• You own the property.

• You use the property in your business or income-producing activity (such as rental property).

• The property has a determinable useful life.

• The property is expected to last more than 1 year.

• The property is not excepted property (such as property placed in service and disposed of in the same year and section 197 intangibles).

Property having a determinable useful life. To be depreciable, your property must have a determinable useful life. This means that it must be something that wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes.

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.

Property you own. To claim depreciation, you usually must be the owner of the property. You are considered as owning property even if it is subject to a debt.

Rented property. Generally, if you pay rent on property, you cannot depreciate that property. Usually, only the owner can depreciate it. If you make permanent improvements to the property, you may be able to depreciate the improvements. See Additions or improvements to property, later.

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. Figure your depreciation deduction as follows.

1. Figure the depreciation for all the depreciable real property owned by the corporation. (Depreciation methods are discussed later.) If you bought your cooperative stock after its first offering, figure the depreciable basis of this property as follows.

   1. Multiply your cost per share by the total number of outstanding shares.

   2. Add to the amount figured in (a) any mortgage debt on the property on the date you bought the stock.

   3. Subtract from the amount figured in (b) any mortgage debt that is not for the depreciable real property, such as the part for the land.

2. Subtract from the amount figured in (1) any depreciation for space owned by the corporation that can be rented but cannot be lived in by tenant-stockholders.

3. Divide the number of your shares of stock by the total number of shares outstanding, including any shares held by the corporation.

4. Multiply the result of (2) by the percentage you figured in (3). This is your depreciation on the stock.

Your depreciation deduction for the year cannot be more than the part of your adjusted basis (defined later) in the stock of the corporation that is allocable to your rental property. See Cooperative apartments under What Property Can Be Depreciated? in chapter 1 of Publication 946 for more information.

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.

Table 3. MACRS Recovery Periods for Property Used in Rental Activities

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.

If you placed property in service before 2006, continue to use the same method of figuring depreciation that you used in the past.

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

Alternative minimum tax. If you use accelerated depreciation, you may have to file Form 6251, Alternative Minimum Tax-Individuals. Accelerated depreciation can be determined under MACRS, ACRS, and any other method that allows you to deduct more depreciation than you could deduct using a straight line method.

Special Depreciation Allowance

You can take a special depreciation allowance (in addition to your regular MACRS depreciation deduction) for qualified Gulf Opportunity Zone (GO Zone) property you placed in service in 2006. The allowance is 50% of the property's depreciable basis. You figure the special depreciation allowance before you figure your regular MACRS deduction.

Qualified Gulf Opportunity Zone Property

Your property is qualified GO Zone property if it meets the following requirements.

1. It is one of the following types of property.

   1. Property depreciated under MACRS with a recovery period of 20 years or less.

   2. Water utility property.

   3. Certain computer software.

   4. Qualified leasehold improvement property.

   5. Certain nonresidential real property and residential rental property.

2. It meets the tests explained next under Other tests to be met.

3. It is not excepted property explained later under Excepted property.

• Acquisition date test.

• Placed-in-service date test.

• Substantial use test.

• Original use test.

Acquisition date test. You must have acquired the property by purchase after August 27, 2005, with no binding written contract for the acquisition in effect before August 28, 2005.

Placed-in-service date test. The property must be placed in service for use in your trade or business or for the production of income before January 1, 2008 (January 1, 2009, in the case of qualifying nonresidential real property and residential rental property).

Substantial use test. Substantially all (80 percent or more) of the use of the property must be in the GO Zone and in the active conduct of your trade or business in the GO Zone.

Original use test. The original use of the property in the GO Zone must have begun with you after August 27, 2005. Used property can be qualified GO Zone property if it has not previously been used within the GO Zone. Also, additional capital expenditures you incurred after August 27, 2005, to recondition or rebuild your property meet the original use test if the original use of the property in the GO Zone began with you. If you sold property you placed in service after August 27, 2005, and you leased it back within 3 months after you originally placed the property in service, the lessor is considered to be the original user of the property.

Excepted property. Qualified GO Zone property does not include any of the following.

• Property required to be depreciated using the Alternative Depreciation System (ADS).

• Property any portion of which is financed with the proceeds of a tax-exempt obligation under section 103 of the Internal Revenue Code.

• Any qualified revitalization building for which you have elected to claim a commercial revitalization deduction for qualified revitalization expenditures.

• Any property used in connection with any private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, or any store, the principal business of which is the sale of alcoholic beverages for consumption off premises.

• Any gambling or animal racing property.

• Property for which you elected not to claim any special depreciation allowance.

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:

1. Its recovery period,

2. Its placed-in-service date, and

3. Its depreciable basis.

Personal home changed to rental use. You must use MACRS to figure the depreciation on property used as your home and changed to rental property in 2006.

Excluded property. You cannot use MACRS for certain personal property placed in service in your rental property in 2006 if it had been previously placed in service before MACRS became effective. Generally, personal property is excluded from MACRS if you (or a person related to you) owned or used it in 1986 or if your tenant is a person (or someone related to the person) who owned or used it in 1986. However, the property is not excluded if your 2006 deduction under MACRS (using a half-year convention) is less than the deduction you would have under ACRS. See Can You Use MACRS To Depreciate Your Property? in 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.

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.

Under GDS, property that you placed in service during 2006 in your rental activities generally falls into one of the following classes. Also see Table 3.

• 5-year property. This class includes computers and peripheral equipment, office machinery (typewriters, calculators, copiers, etc.), automobiles, and light trucks.

  This class also includes appliances, carpeting, furniture, etc., used in a residential rental real estate activity.

  Depreciation on automobiles, certain computers, and cellular telephones is limited. See chapter 5 of Publication 946.

• 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 roads and shrubbery (if depreciable).

• Residential rental property. This class includes any real property that is a rental building or structure (including a mobile home) for which 80% or more of the gross rental income for the tax year is from dwelling units. It does not include a unit in a hotel, motel, inn, or other establishment where more than half of the units are used on a transient basis. If you live in any part of the building or structure, the gross rental income includes the fair rental value of the part you live in. The recovery period for residential rental property is 27.5 years.

The other property 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. Shorter recovery periods were provided under MACRS for qualified Indian reservation property placed in service on Indian reservations before 2006. For more information, see chapter 4 of 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:

1. The date the addition or improvement is placed in service, or

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

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 placed it in service in 2006. 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.

Example 1.

On November 22 of last year, you purchased a dishwasher for your rental property. The appliance was delivered on December 7, but was not installed and ready for use until January 3 of this year. Because the dishwasher was not ready for use last year, it is not considered placed in service until this year.

If the appliance had been ready for use when it was delivered in December of last year, it would have been considered placed in service in December, even if it was not actually used until this year.

Example 2.

On April 6, you purchased a house to use as residential rental property. You made extensive repairs to the house and had it ready for rent on July 5. You began to advertise the house for rent in July and actually rented it beginning September 1. The house is considered placed in service in July when it was ready and available for rent. You can begin to depreciate the house in July.

Example 3.

You moved from your home in July. During August and September you made several repairs to the house. On October 1, you listed the property for rent with a real estate company, which rented it on December 1. The property is considered placed in service on October 1, the date when it was available for rent.

Depreciable Basis

The depreciable basis of property used in a rental activity is generally its adjusted basis when you place it in service in that activity. This is its cost or other basis when you acquired it, adjusted for certain items occurring before you place it in service in the rental activity.

If you depreciate your property under MACRS, you may also have to reduce your basis by certain deductions and credits with respect to the property.

Basis and adjusted basis are explained in the following discussions.

Cost Basis

The basis of property you buy is usually its cost. The cost is the amount you pay for it in cash, in debt obligation, in other property, or in services. Your cost also includes amounts you pay for:

• Sales tax charged on the purchase (see Caution below),

• Freight charges to obtain the property, and

• Installation and testing charges.

At the time this publication went to print, Congress was considering legislation that would extend the deduction for state and local general sales tax that expired at the end of 2005. If this deduction is extended, you may be able to take a deduction for your state and local general sales taxes instead of state and local income taxes as an itemized deduction on Schedule A (Form 1040). If you make that choice, you cannot include those sales taxes as part of your cost basis. To find out if this legislation was enacted, and for more details, go to http://www.irs.gov/, click on More Forms and Publications , and then on What's Hot in forms and publications , or see Publication 553, Highlights of 2006 Tax Changes.

Loans with low or no interest. If you buy property on any time-payment plan that charges little or no interest, the basis of your property is your stated purchase price, less the amount considered to be unstated interest. See Unstated Interest and Original Issue Discount in Publication 537, Installment Sales.

Real property. If you buy real property, such as a building and land, certain fees and other expenses you pay are part of your cost basis in the property.

Real estate taxes. If you buy real property and agree to pay real estate taxes on it that were owed by the seller and the seller did not reimburse you, the taxes you pay are treated as part of your basis in the property. You cannot deduct them as taxes paid. If you reimburse the seller for real estate taxes the seller paid for you, you can usually deduct that amount. Do not include that amount in your basis in the property.

Settlement fees and other costs. Settlement fees and closing costs that are for buying the property are part of your basis in the 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 you agree to pay, such as back taxes or interest, recording or mortgage fees, charges for improvements or repairs, and sales commissions.

1. Fire insurance premiums,

2. Rent or other charges relating to occupancy of the property before closing, and

3. Charges connected with getting or refinancing a loan, such as:

   1. Points (discount points, loan origination fees),

   2. Mortgage insurance premiums,

   3. Loan assumption fees,

   4. Cost of a credit report, and

   5. Fees for an appraisal required by a lender.

Also, do not include amounts placed in escrow for the future payment of items such as taxes and insurance.

Assumption of a mortgage. If you buy property and become liable for an existing mortgage on the property, your basis is the amount you pay for the property plus the amount that still must be paid on the mortgage.

Example.

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

Example.

You buy a house and land for $100,000. The purchase contract does not specify how much of the purchase price is for the house and how much is for the land.

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

You can allocate 85% ($68,000 ÷ $80,000) of the purchase price to the house and 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 Cost

There are many times when you cannot use cost as a basis. You cannot use cost as a basis 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

• As an inheritance.

If you received property in one of these ways, see Publication 551 for information on how to figure your basis.

Adjusted Basis

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

• The cost of any additions or improvements having a useful life of more than one year,

• Amounts spent after a casualty to restore the damaged property,

• The cost of extending utility service lines to the property, and

• Legal fees, such as the cost of defending and perfecting title.

Additions or improvements. Add to the basis of your property the amount an addition or improvement actually cost you, including any amount you borrowed to make the addition or improvement. This includes all direct costs, such as material and labor, but not your own labor. It also includes all expenses related to the addition or improvement. For example, if you had an architect draw up plans for remodeling your property, the architect's fee is a part of the cost of the remodeling. Or, if you had your lot surveyed to put up a fence, the cost of the survey is a part of the cost of the fence. Keep separate accounts for depreciable additions or improvements made after you place the property in service in your rental activity. For information on depreciating additions or improvements, see Additions or improvements to property, earlier, under Recovery Periods Under GDS. The cost of landscaping improvements is usually treated as an addition to the basis of the land, which is not depreciable. See What Property Can Be Depreciated, earlier.

Assessments for local improvements. Assessments for items which tend to increase the value of property, such as streets and sidewalks, must be added to the basis of the property. For example, if your city installs curbing on the street in front of your house, and assesses you and your neighbors for the cost of curbing, you must add the assessment to the basis of your property. Also add the cost of legal fees paid to obtain a decrease in an assessment levied against property to pay for local improvements. You cannot deduct these items as taxes or depreciate them. Assessments for maintenance or repair or meeting interest charges are deductible as taxes. Do not add them to your basis in the property.

Deducting vs. capitalizing costs. You cannot add to your basis costs that are deductible as current expenses. However, there are certain costs you can choose either to deduct or to capitalize. If you capitalize these costs, include them in your basis. If you deduct them, do not include them in your basis. The costs you may be able to choose to deduct or to capitalize include carrying charges, such as interest and taxes, that you must pay to own property. For more information about deducting or capitalizing costs, see chapter 7 in Publication 535.

Decreases to basis. You must decrease the basis of your property by any items that represent a return of your cost. These include:

• The amount of any insurance or other payment you receive as the result of a casualty or theft loss,

• Any deductible casualty loss not covered by insurance,

• Any amount you receive for granting an easement,

• Any residential energy credit you were allowed before 1986, or after 2005, if you added the cost of the energy items to the basis of your home, and

• The amount of depreciation you could have deducted on your tax returns under the method of depreciation you selected. If you took less depreciation than you could have under the method you selected, you must decrease the basis by the amount you could have taken under that method.

Basis of Property Changed to Rental Use

When you change property you held for personal use to rental use (for example, you rent your former home), you figure the basis for depreciation using the lesser of fair market value or adjusted basis.

Fair market value. This is the price at which the property would change hands between a buyer and a seller, neither having to buy or sell, and both having reasonable knowledge of all the relevant facts. Sales of similar property, on or about the same date, may be helpful in figuring the fair market value of the property.

Figuring the basis. The basis for depreciation is the lesser of:

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

• Your adjusted basis on the date of the change—that is, your original cost or other basis of the property, plus the cost of permanent additions or improvements since you acquired it, minus deductions for any casualty or theft losses claimed on earlier years' income tax returns and other decreases to basis.

Example.

Several years ago you built your home for $140,000 on a lot that cost you $14,000. Before changing the property to rental use last year, you added $28,000 of permanent improvements to the house and claimed a $3,500 deduction for a casualty loss to the house. Because land is not depreciable, you can only include the cost of the house when figuring the basis for depreciation.

The adjusted basis of the house at the time of the change in use was $164,500 ($140,000 + $28,000 - $3,500).

On the date of the change in use, your property had a fair market value of $168,000, of which $21,000 was for the land and $147,000 was for the house.

The basis for depreciation on the house is the fair market value at the date of the change ($147,000), because it is less than your adjusted basis ($164,500).

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:

• Actually compute the deduction using the depreciation method and convention that apply over the recovery period of the property, or

• Use the percentage from the optional MACRS tables, shown later.

If you actually compute the deduction, the depreciation method you use depends on the class of the property.

5-, 7-, or 15-year property. For property in the 5- or 7-year class, use the 200% declining balance method and a half-year convention. However, in limited cases you must use the mid-quarter convention, if it applies. These conventions are explained later. For property in the 15-year class, use the 150% declining balance method and a half-year convention. You can also choose to use the 150% declining balance method for property in the 5- or 7-year class. The choice to use the 150% method for one item in a class of property applies to all property in that class that is placed in service during the tax year of the election. You make this election on Form 4562. In Part III, column (f), enter “150 DB.” If you use either the 200% or 150% declining balance method, you figure your deduction using the straight line method in the first tax year that the straight line method gives you an equal or larger deduction. You can also choose to use the straight line method with a half-year or mid-quarter convention for 5-, 7-, or 15-year property. The choice to use the straight line method for one item in a class of property applies to all property in that class that is placed in service during the tax year of the election. You elect the straight line method on Form 4562. In Part III, column (f), enter “S/L.” Once you make this election, you cannot change to another method.

Residential rental property. You must use the straight line method and a mid-month convention for residential rental property.

Declining Balance Method

To figure your MACRS deduction, first determine your declining balance rate from the table on the next page. However, if you elect to use the 150% declining balance method for 5- or 7-year property, figure the declining balance rate by dividing 1.5 (150%) by the recovery period for the property.

In the first tax year, multiply the adjusted basis of the property by the declining balance rate and apply the appropriate convention to figure your depreciation. In later years (before the year you switch to the straight line method), use the following steps to figure your depreciation.

1. Reduce your adjusted basis by the depreciation allowable for the earlier years.

2. Multiply the new adjusted basis in (1) by the same rate used in earlier years.

See Conventions, later, for information on depreciation in the year you dispose of property.

Straight Line Method

To figure your MACRS deduction under the straight line method, you must apply a different depreciation rate to the adjusted basis of your property for each tax year in the recovery period.

In the first year, multiply the adjusted basis of the property by the straight line rate. You must figure the depreciation for the first year using the convention that applies. (See Conventions, later.)

Example.

You place in service property with a basis of $1,000 and a 5-year recovery period. The straight line rate is 20% (1 divided by 5) for the first tax year. After you apply the half-year convention, the first year rate is 10% (20% divided by 2). Depreciation for the first year is $100.

At the beginning of the second year, the remaining recovery period is 4½ years because of the half-year convention. The straight line rate for the second year is 22.22% (1 divided by 4.5).

To figure your depreciation deduction for the second year:

1. Subtract the depreciation taken in the first year ($100) from the basis of the property ($1,000), and

2. Multiply the remaining basis ($900) by 22.22%. The depreciation for the second year is $200.

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 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 year. 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, Tom Martin 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.

Tom uses the calendar year as his tax year. The total basis of all property placed in service 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). Tom must use the mid-quarter convention instead of the half-year convention for all three items.

Optional Tables

You can use the tables in Table 4 to compute annual depreciation under MACRS. The tables show the percentages for the first 6 years. See Appendix A of Publication 946 for complete tables. The percentages in Tables 4-A, 4-B, and 4-C make the change from declining balance to straight line in the year that straight line will yield a larger deduction. See Declining Balance Method, earlier.

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

1. Depreciation allowed or allowable, or

2. An addition or improvement that is depreciated as a separate item of property.

If there is an adjustment for any reason other than (1) or (2) (for example, because of a deductible casualty loss) you can no longer use the table. For the year of the adjustment and for the remaining recovery period, figure depreciation using the property's adjusted basis at the end of the year and the appropriate depreciation method, as explained earlier under MACRS Depreciation Under GDS.

Tables 4-A, 4-B, and 4-C. The percentages in these tables take into account the half-year and mid-quarter conventions. Use Table 4-A for 5-year property, Table 4-B for 7-year property, and Table 4-C for 15-year property. Use the percentage in the second column (half-year convention) unless you must use the mid-quarter convention (explained earlier). If you must use the mid-quarter convention, use the column that corresponds to the calendar year quarter in which you placed the property in service.

Example 1.

You purchased a stove and refrigerator and placed them in service in June. Your basis in the stove is $600 and your basis in the refrigerator is $1,000. Both are 5-year property. Using the half-year convention column in Table 4-A, you find the depreciation percentage for year 1 is 20%. For that year your depreciation deduction is $120 ($600 × .20) for the stove and $200 ($1,000 × .20) for the refrigerator.

For year 2, you find your depreciation percentage is 32%. That year's depreciation deduction will be $192 ($600 × .32) for the stove and $320 ($1,000 × .32) for the refrigerator.

Example 2.

Assume the same facts as in Example 1, except you buy the refrigerator in October instead of June. You must use the mid-quarter convention to figure depreciation on the stove and refrigerator. The refrigerator was placed in service in the last 3 months of the tax year, and its basis ($1,000) is more than 40% of the total basis of all property placed in service during the year ($1,600 × .40 = $640).

Because you placed the refrigerator in service in October, you use the fourth quarter column of Table 4-A and find that the depreciation percentage for year 1 is 5%. Your depreciation deduction for the refrigerator is $50 ($1,000 × .05).

Because you placed the stove in service in June, you use the second quarter column of Table 4-A and find that the depreciation percentage for year 1 is 25%. For that year, your depreciation deduction for the stove is $150 ($600 × .25).

Example.

You purchased a single family rental house and placed it in service in February. Your basis in the house is $160,000. Using Table 4-D, you find that the percentage for property placed in service in February of year 1 is 3.182%. That year's depreciation deduction is $5,091 ($160,000 × .03182).

MACRS Depreciation Under ADS

If you choose, you can use the ADS method for most property. Under ADS, you use the straight line method of depreciation.

Table 3 shows the recovery periods for property used in rental activities that you depreciate under ADS.

See Appendix B in Publication 946 for other property. If your property is not listed, it is considered to have no class life. Under ADS, personal property with no class life is depreciated using a recovery period of 12 years.

Use the mid-month convention for residential rental property and nonresidential real property. For all other property, use the half-year or mid-quarter convention.

Casualties and Thefts

As a result of a casualty or theft, you may have a loss related to your property. You may be able to deduct the loss on your income tax return. For information on casualty and theft losses (business and nonbusiness), see Publication 547.

Casualty. Damage to, destruction of, or loss of property is a casualty if it results from an identifiable event that is sudden, unexpected, or unusual.

Theft. The unlawful taking and removing of your money or property with the intent to deprive you of it is a theft.

Gain from casualty or theft. When you have a casualty to, or theft of, your property and you receive money, including insurance, that is more than your adjusted basis in the property, you generally must report the gain. However, under certain circumstances, you may defer paying tax by choosing to postpone reporting the gain. To do this, you must generally buy replacement property within 2 years after the close of the first tax year in which any part of your gain is realized. The cost of the replacement property must be equal to or more than the net insurance or other payment you received. For more information, see Publication 547.

How to report. If you had a casualty or theft that involved property used in your rental activity, you figure the net gain or loss in Section B of Form 4684, Casualties and Thefts. Also, you may have to report the net gain or loss from Form 4684 on Form 4797, Sales of Business Property. (Follow the instructions for Form 4684.)

Limits on Rental Losses

Rental real estate activities are generally considered passive activities, and the amount of loss you can deduct is limited. Generally, you cannot deduct losses from rental real estate activities unless you