I think we pretty well covered the net passive loss allowance, but there are income tax return impacts related to depreciation that were not addressed.
First, if you are a residential rental property owner, your cost recovery period is 27.5 years. If you fail to take an allowable depreciation expense, the IRS will tax unrecaptured depreciation that you took or should have taken when the property is sold. This is what “depreciation recapture” is all about. Unrecaptured depreciation is “recaptured” at a 25% tax rate, regardless of your tax bracket.
Generally, the purchase price for your investment rental property buys the rental dwelling structure AND the land it sits on. Only the structure can be depreciated – land can not be depreciated. You have to allocate your purchase price between the structure and the land, and your allocation must be reasonable and defendable to the IRS. The portion of your purchase price allocated to the structure is your “depreciable basis.”
Personal property, such as a washer/dryer or furniture that you put in your rental property for your tenant’s use can be depreciated on either a five or seven year schedule, depending upon the applicable asset class.
As you replace major components of your rental property, you create a new asset for depreciation. For example, replace the roof on your rental property, and the new roof becomes a new depreciation asset with its own 27.5 year cost recovery period.
Here is one depreciation pitfall that a lot of investors are not aware of. One of the great tax loopholes still available to investment property owners is the 1031 tax-deferred exchange. If you use a 1031 exchange to replace your partially depreciated rental property with another rental property, the adjusted basis in the relinquished property is carried forward to the replacement property and depreciated over the remainder of the old depreciation schedule.
For example, let’s say your rental property has an adjusted cost basis of $37K with 14 years still left on your depreciation schedule. The adjusted cost basis in your relinquished property becomes the initial cost basis in your replacement property, and you only have 14 years left on the depreciation schedule for this basis in your replacement property. Let’s call this basis, OLD BASIS, since it is carried over to the replacement property from the old, relinquished property.
Most likely, the replacement property cost more than the sale price of the relinquished property and you have to bring your own cash and/or additional financing to the settlement table to complete the replacement property acquisition. Any new money and additional debt that you bring to the replacement property acquisition is also included in the total cost basis in the replacement property. Let’s call this basis the NEW BASIS. The new basis is a new depreciable asset with its own 27.5 year recovery period.
So, your cost basis in the replacement property has two components, the OLD BASIS and the NEW BASIS. A lot of investors will just compute the total cost basis in the new property, and begin a new 27.5 year depreciation schedule without separating the replacement property basis into OLD and NEW basis components, each with a separate depreciation schedule.
Even a very popular and highly recommended personal tax preparation software package, TurboTax, does not automatically do this for the taxpayer. This allocation of the replacement property basis between OLD and NEW components must be manually entered into the rental property depreciation asset scheldule in TurboTax.