How to Depreciate Residential Improvements
Depreciation of value in residential real estate is an annual tax deduction the Internal Revenue Service (IRS) allows for property owners to cover losses due to wear and tear, deterioration or obsolescence. The IRS only recognizes depreciation for rental or investment residential property -- that is, any residential property used to generate income. The IRS requires property owners to report improvements to a property as a separate depreciable property using IRS Form 4562. For example, upgrading a rental home's windows qualifies as an improvement, but replacing one broken pane does not.
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Instructions
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Categorize the improvements you plan to depreciate based on the type of property you improved, such as residential property you rent to people or residential property you rent from someone. If you improve another person's rental property, you can claim the improvement's depreciation on your taxes. Confirm the total cost of each improvement with source documents, such as receipts, invoices and work orders that prove the amount of money you initially spent on the improvements. All documentation should at least include the date and amount of each transaction, as well as a brief description, according to Net MBA.
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Recognize the time constraints for each improvement that qualifies for depreciation. The IRS allows a property owner to claim depreciation from the moment that property is used to generate income until the owner either fully recovers the costs or no longer uses it, whichever comes first. The IRS standardizes depreciation based upon the initial value of the improvement and the number of years it has been in use. However, a property owner cannot claim depreciation if he buys and sells the same residential property in the same year, so any improvements must be considered part of the appraised value of the property.
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Determine which properties and improvements to depreciate using the Modified Accelerated Cost Recovery System (MACRS) and which to depreciate using the Accelerated Cost Recovery System (ACRS). Use MACRS for improvements made after Dec. 31, 1986, and ACRS for improvements made before Jan. 1, 1987. Report MACRS and ACRS depreciation for residential improvements to the IRS using Form 4562.
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Calculate each improvement's annual depreciation expense using MACRS or ACRS. ACRS assumes a lifespan of 31.5 years for residential properties, but the Tax Reform Act of 1986 lowered that span to 27.5 years for MACRS. For a $10,000 improvement, for example, calculate annual depreciation by dividing the value of the improvement by 31.5 for ACRS and 27.5 for MACRS. ACRS annual depreciation would be $317.46, but MACRS annual depreciation would be $363.63.
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Report annual depreciation claims to the IRS on Form 4562, using a different form for each claim of depreciation. For each subsequent tax year, use the previous year's depreciated value when calculating each residential improvement's depreciation. If you are calculating depreciation for more than one year, begin with the initial value of the improvement and depreciate it year by year. Keep a source document for each claim you make in case the IRS audits your tax filings.
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Tips & Warnings
Consult an accountant and a property appraiser as you calculate depreciation and report it to the IRS.
Taxpayers who claim depreciation might also be liable for the Alternative Minimum Tax (AMT), depending upon your income and its sources as well as your tax bracket and filing status.
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