Can I Depreciate a Foreclosed Rental Property?
Whether the Internal Revenue Service (IRS) will permit you to depreciate a foreclosed rental property depends upon the circumstances surrounding ownership of the property. Your eligibility differs based upon whether the bank forecloses on a previous purchase you made or you purchase a foreclosed property to rent to others. In some cases, the IRS may require you to recapture depreciation that you previously claimed, reporting it as income in the year of foreclosure.
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Purchasing a Foreclosure
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If you purchase a foreclosure, even if you take out a mortgage to make the purchase, the IRS permits you to claim a depreciation deduction for the rental property. In order to depreciate rental property you must be the owner, cannot purchase the property and take it out of service for business purposes within the same year and it must have a determinable useful life. Generally, you claim the depreciation deduction until you recover the full cost of the property or until you no longer rent the property to generate income.
Determining Basis
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The basis of the foreclosed rental property is the purchase price of the property plus the cost of any capital improvements you make the property. The purchase price of the property includes the cash you pay or mortgage you assume to buy the property, real estate and transfer taxes, legal fees, title insurance, recording fees and charges for installation of utilities. If you agree to pay any back taxes or mortgage payments for the property, you also include these in the basis of the property. The cost of any capital improvements, those which increase the property value, are also included in the basis of the property. The total basis is the amount that you can depreciate over the life of the property.
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Foreclosing on Your Property
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If the bank forecloses on your property, then you cannot continue to claim the depreciation tax deduction on that property. The IRS only permits claiming depreciation for property that generates income. The IRS treats a foreclosure as a sale of the rental property, from which your debts are forgiven. This may actually result in a need to recapture any depreciation that you previously claimed as income.
Depreciation Recapture
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If you experience a gain on the foreclosure of the property, then you must claim any additional depreciation that you claimed as ordinary income on your tax return in the year of foreclosure. You receive a gain on the property when the amount of debt that you are forgiven, known as your amount realized, exceeds your adjusted basis in the property. Your adjusted basis is your cost basis less any tax deductions you claimed for depreciation over your years of ownership. The additional depreciation is any amount you claimed that exceeds what you would have claimed in you had used the straight-line method of depreciation. The straight-line method means that you claim the same amount every year until you fully recover the cost of the property.
Example
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For example, if you decide that your rental property has a useful life of 20 years and your basis in the property $200,000, you would claim a depreciation deduction of $10,000 for each full year. However, if you use the double declining balance method, you would claim $20,000 in the first full year and $18,947 in the second year. You must report 100 percent of your additional depreciation as income. In this case, you would report the extra $10,000 as income for the first year and $8,947 for the second year.
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