Rental tax question depreciation confusion

[Chris Clemptor]

     I understand that you can subtract from your tax burden on a rental property using depreciation.  I also read that it's based on the house value only, not including the land.  I am wondering how most people figure out what number to use, to divide by 27.5?  Do you have to get an appraisal?

    A little bit more info about my situation is I bought a house, originally built in 1957,  5.5 years ago for 85,000.  I then spent the next 5 years living in it alone and renovating in my spare time, I personally did all the labor myself, and I would estimate I spent 60,000 on materials during that time.  I made the house into 2 units where I live in the basement unit, and I finally rented out the top portion of the house for the first time, 4 months ago.

    Some other confusing issues are the schedule E tax form allows me to deduct materials and labor. I did not pay any labor but I did buy 60k in materials over the last 5 years. How is this figured? Is this divided over the 27.5 year period? Also  when does the 27.5 year span begin? Is it when the first tenet moved in?

       Because of inflation ten years from now the house will most likely have a higher price so that higher number if divided by 27.5 would be more and would be a benefit to me having a higher number that can be subtracted from my tax burden. How does recalculating the 27.5 year issue work? Another weird issue to me is  if you get to deduct labor and materials and also deduct for depreciation it seems your getting double the benefit because if labor and materials made your house value double, this number divided by 27.5 would also be double what it was before, and since you subtract this from your tax burden, you pay less taxes in 2 ways.

Any help is appreciated.

[Paul Caputo]

Ok so here's where you should be on your depreciation from the info you've given. Depreciation only happens on commercial and rental property, so the part of your home that you still occupy cannot be depreciated until you move out and start renting it to someone. You are also correct that land is not included in depreciable value: since land doesn't "wear out" it is non-depreciable. There should have been some sort of appraisal when you bought the property, and your property taxes should also indicate your land value. Usually the land value is around 20% of the purchase price, but that can vary widely depending on the property. Depreciation is the IRS giving you a long term tax deduction to recover your costs of ownership. There's a difference between depreciating something and expensing it, you want to expense as much as possible because there's depreciation recapture upon sale and there's no such recapture for expenses. The tricky part is knowing what can be expensed and what has to be depreciated so most go the "safe" route and depreciate everything

Depreciation begins when the property is placed in service, so for your upstairs rental that means when it was ready to be rented and was no longer being used as your residence. Basically if you had it all ready in October and were actively looking for a tenant in October but didn't get it rented until December it was placed in service in October because that's when you could have had it rented even though you didn't. In your situation the initial depreciable cost basis would be the proportional value of the home and improvements based on how much is used as a rental. If the basement and the upstairs are the same size then it's 50/50 on the property value, if they're not you go proportionally by square footage. If you split the improvements between the basement and upstairs evenly then that gets split 50/50, If only 25% of the improvements went to the basement and 75% went to the upstairs then you split accordingly. 

So just to plug your numbers in it might look like this: 

Purchase Price: $85K (Doesn't matter that you bought it 5.5 years ago, this is what you paid)

Improvements: $60K (too bad you did it all yourself you lose out on adding labor cost here)

Land Value: $15K (this is a little under 20%, you should get the actual value)

Building Value: $70K (Purchase price minus land value)

Rental Value: $35K (If it's split 50/50)

Rental improvements Value: $30K (again if it is split 50/50)

Depreciable Cost Basis: $65K (Rental Value plus rental improvements Value)

So with that you'd be looking at a $2,363.63 depreciation deduction every year for 27.5 years. The first and last year are adjusted based on when the property was placed in service. This deduction lowers your taxable income, so the actual value of the deduction is based on your tax rate. At a 40% tax rate a $2,000 deduction is worth $800, while at a 25% tax rate the same deduction is only worth $500. 

Hope this helps let me know if you have any other questions on depreciation.