Depreciation refers to the process of writing off the cost of a property over time due to its usage and wear and tear. This concept implies that as property is used, it loses value, and this loss needs to be accounted for (deducted) over time. This thinking is reflected in rental home depreciation. Notably, land is not depreciated as it is timeless, and the base for depreciation is the lesser of the cost basis or the fair market value (FMV) as you cannot lose what you currently have. For the purpose of this discussion, we assume, without losing generality, the FMV is higher than the cost basis, which is commonly the case.

Even if the value of the rental property does not decrease, the IRS allows for depreciation to recover the cost of the property over time through tax deductions. For rental properties in the United States, the depreciation period is set at 27.5 years according to IRC Section 168(c). Depreciation reduces the cost basis of the property as it has been used to offset the rental income, if the value of the property is greater than the adjusted cost basis when the property is sold, the depreciation is partially or fully recaptured.

In standard rental situations, depreciation starts when the property is ready for rent and stops when it is sold, converted to personal use, or after the 27.5-year period. However, complexities arise when a rental property switches between business use and personal use, or when the business use percentage changes.

Discontinued Periods of Rental Use

Consider a scenario where a rental home is rented for about 4 years, then converted to personal use for about 2 years, and then rented again starting 07/04/2024. Here’s an example of such a situation:

Start End Months Basis Depreciated Accumulated
06/19/2018 12/31/2018 6.50 600,000 11818 11818
01/01/2019 12/31/2019 12.00 600,000 21818 33636
01/01/2020 12/31/2020 12.00 600,000 21818 55454
01/01/2021 12/31/2021 12.00 600,000 21818 77272
01/01/2022 05/20/2022 4.50 600,000 8182 85454
01/01/2023 12/31/2023 12.00 not rented 0 85454
07/04/2024 12/31/2024 12.00 514,546 8576 94030

In this scenario, you cannot simply resume the original depreciation schedule.

  • Continuing with the original depreciation starting date and basis would depreciate the property during the personal use period.
  • Changing the depreciation starting date to July 4, 2024, without adjusting the cost basis, would allow full depreciation again on top of what has already been deducted.

I recommend starting a new depreciation schedule when a rental property experiences a significant change in use, such as a period of personal use.

  • This new schedule would begin on July 4, 2024.
  • The depreciation cost for the new schedule would be adjusted to the original cost basis minus the accumulated depreciation from the previous schedule.
  • This accumulated depreciation should be tracked. When selling the property, you can use this information to calculate capital gains.

The benefits of this approach include:

  • It allows the cost basis to be fully and correctly depreciated. While you technically get another 27.5 years of depreciation, the total amount of depreciation won’t exceed the original cost basis. This is a correct approach per CFR 1.168(i)-4(b) since you have a change in use.
  • It simplifies record-keeping as you only need the current schedule to calculate the capital gain when then rental is sold.

Rental Property with Varied Business Use Percentages

Now, let’s explore situations where the business use percentage of a property changes:

  • Increased Business Use:

    • You continue the existing depreciation schedule for the original portion of the property.
    • Additionally, you create a new depreciation schedule for the increased business use percentage, with a new starting date and a cost basis reflecting the increased portion’s value.
    • Alternatively, you can stop the current depreciation, and start a new schedule in the similar manner as in “Discontinued Periods of Rental Use”.

  • Decreased Business Use:

    Since adding a negative depreciation schedule isn’t allowed, the recommended approach is to start a new depreciation schedule with:

    • A new starting date reflecting the change in use.
    • A new cost basis reflecting the original basis minus the accumulated depreciation from the previous schedule.

Conclusion:

Depreciation calculations can become complex when dealing with rental properties with varied use in time and space. My recommended method benefits the taxpayers while staying compliant with the IRS guidelines, and is easy to maintain.