This guest blog on the depreciation considerations of real estate is contributed by Tracey Smith, a Certified Management Accountant and an Enrolled Agent (qualified to practice before the IRS), in addition to being the founder of Women’s Financial Help Desk, a tax and accountancy firm dedicated to helping people manage and grow their business.
The first part of this two-part series on depreciation for tax purposes outlined the basics of what depreciation is, and what is included in the cost or “basis” of the asset to be depreciated. In this Part 2, we’ll discuss how to calculate the amount to be deducted for tax purposes, the sections of the tax code that affect depreciation deductions, and the new regulations regarding repairs versus improvements.
Calculating the Depreciation Tax Deduction
The Modified Accelerated Cost Recovery System (MACRS) is used to recover the basis of most business and investment property placed in service after 1986 (i.e. the date of the last major overhaul of the tax code). MACRS consists of two depreciation systems: 1) the General Depreciation System (GDS), and 2) the Alternative Depreciation System (ADS). Generally, these systems provide different methods and recovery periods to use in figuring depreciation deductions. To simplify things, we are only going to discuss depreciating property under GDS, as it applies to the majority of assets placed in service.
To figure your depreciation deduction, you must determine the:
- property class,
- placed-in-service date,
- basis amount,
- recovery period,
- convention, and
- depreciation method that applies to your property.
The property class of an asset will determine the number of years over which the asset will be deducted (expensed) on the tax return (the recovery period). There are nine property classes under GDS, but the most important for real estate are residential rental property, which is written off over 27.5 years, and non-residential real property, which is expensed over 39 years.
The placed in service date and convention affect the depreciation amount claimed in the first and last years of the asset’s life, but there is no need to go into them here.
While there are three depreciation methods that could conceivably be used under GDS over a recovery period (200% declining balance, 150% declining balance, and straight line), it is the straight line method that is used for residential rental property and non-residential real property. This depreciation method is technically the easiest to understand, yet the calculation of your tax deduction is not as simple as taking the basis and dividing it by the recovery period, because the placed-in-service date and convention rules must also be taken into account. In the end, one must use the IRS tables or computer software to calculate the deduction.
To illustrate, the IRS gives the following example in their Publication 527 on residential rental property:
You purchased a single family rental house for $185,000 and placed it in service on February 8. The sales contract showed that the building cost was $160,000 and the land cost $25,000. Your basis for depreciation is its original cost, namely $160,000. This is the first year of service for your residential rental property and you decide to use GDS which has a recovery period of 27.5 years. Using Table 2-2d of this IRS publication, you find that the percentage for property placed in service in February of Year 1 is 3.182%. That year's depreciation deduction would therefore be $5,091 ($160,000 x .03182).
Section 179 Deduction
There are several sections of the Internal Revenue Code that impact the depreciation deduction for tax purposes. If you have ever received a K-1 tax return from a pass-through entity such as a partnership or S Corporation, you might be familiar with the Section 179 deduction, which allows businesses to deduct the full purchase price of qualifying equipment or software that was purchased or financed during the tax year. This means the business gets to take the deduction right away instead of depreciating it over its recovery period. Not all property is subject to the Section 179 deduction, however, and real estate generally does not qualify.
Sections 1231, 1245 and 1250
Sections 1231, 1245 and 1250 of the tax code relate to depreciation recapture when an asset is sold, and are very complex. Section 1231 property is defined as depreciable, and real property (including land) that is held for more than a year. Section 1245 property includes depreciable assets held by a business for integral use, and Section 1250 property includes real estate and real property subject to depreciation that is not, and has not been, Section 1245 property. Clear as mud, right?
In a nutshell, when you dispose of depreciable property (Section 1245 property or Section 1250 property) at a gain, you may have to recognize that part of the gain that had previously been written off as a depreciation expense as ordinary income, under the depreciation “recapture” rules. Any remaining gain is a Section 1231 gain (i.e. a capital gain). The takeaway here is that Sections 1245 and 1250 gains (portions that can be tied to earlier deprecation write-offs) are treated as ordinary income and are taxed at one’s marginal tax rate, while Section 1231 gains are taxed at the lower capital gains tax rate. Both Section 1231 and 1250 gains are itemized on a Form K-1 from a pass-through entity.
New Regulations Governing Repairs and Capitalization
A recent development affecting depreciation occurred in the fall of 2013, when the IRS issued new regulations governing when taxpayers must capitalize, and when they can deduct, their expenses for acquiring, maintaining, repairing and/or replacing tangible property. These new regulations are a direct result of the IRS losing some big tax court cases on this topic, most notably the FedEx case.
Prior to the issuance of these regulations, there were no specific rules as to what constituted an improvement to a property (the cost of which would have to be capitalized and written off over time), and what were merely repairs or maintenance that could be fully expensed on the tax return in the current year. Taxpayers and their accountants took a much more liberal view than the IRS, and since the rules had been so loosely defined, the IRS did not prevail in court.
These new regulations were designed to stop what the IRS saw as excessive deductions by large taxpayers such as FedEx. Small businesses must comply with these new rules as well, however, and although there are some special accommodations for small businesses, the new regulations will likely make it much more difficult for these smaller businesses to maintain depreciation schedules.
For example, say a roof replacement used to be able to expensed in the current year as a repair; under the new rules, however, one will have to capitalize the new roof and write it off over time.
The new rules may also have an impact on how businesses maintain their property. Amounts spent for “routine maintenance” can be expensed in the current year. The regulations now define “routine maintenance” as an activity that is generally required to be performed more than once during a ten year period. Businesses will have to weigh the costs and benefits of performing some maintenance activities more often in order to be able to deduct the entire expense in the year it is performed. An example of this is would be painting the building which previously may have only been done every seven years.
As you can see, depreciation for tax purposes is a very complex subject. This two-part blog series has attempted to provide a very broad overview of the subject. If you would like to delve further into this topic, you can review IRS publications 527, 551, 946 and T.D. 9636, or contact us here at Womens’ Financial Help Desk for assistance.