Classes of Property 

You will need to classify the “class” of the property involved with your investment. This is a very critical process that, unfortunately, most investors and their accountants only partially complete. Here are the four steps (five, for California and some other states!):

1.Break out the value of the land separately from the structure. Land is not depreciable. Here’s a tip: Many times the value of a bare lot in the area plus the cost of the construction does not equal the total purchase price. The professionals compare the assessor’s statement of value for the land and building with the purchase price. Use the same ratio that the assessor used for land to building against the total price for your property to determine the value ratio between land and building.

2.Break out the value of personal property items (chattels) within your building. The best way to do this is to have an appraiser help you with the value of these items, or check out ChattelAppraisals.com for help in determining the  value of all personal property items. If you can’t find an appraiser in your area, use the fair market value (FMV) of the personal property items, and then compare that value with the total cost of the building. Generally, it’s hard to substantiate more than 30-40 percent of total building value in personal property items. Personal property items are depreciated over a shorter lifespan, typically ranging from 7 to 15 years.

3.The value of the structure is the total price less land less personal property. This is then depreciated as real property. Currently, real property used for residential rental purposes is depreciated over 27.5 years, and real property used for commercial purposes is depreciated over 39 years. If a property was placed in service prior to May 13, 1993, it will have different depreciation

4.The depreciation for real and personal property is then subtracted from yor operating income for the property. (Operating income means that you have deducted the costs of the property, such as mortgage interest, property tax, insurance, homeowner’s dues, utilities, and repairs as well as your business expenses).

5.In some states, such as California, you are also required to keep depreciation schedules using the state’s assignment of life. This is where you really need to have a good tax software program. Otherwise, you are going to compile a lot of spreadsheets!

How to Catch Up Past Accelerated Depreciation

The step that many taxpayers miss is #2, because they forget to take out the value of personal property. Internal estimates based on a review of the clients’ past records, indicate that more than 90 percent of those returns had made this very common mistake. This mistake cost those taxpayers thousands of dollars each!

However, if you have made this common mistake in the past, don’t despair. You can recover the past depreciation with your next tax return by filing a Form 3115 and attaching  a statement.
What Happens When You Sell?

When you sell your property, you will be required to recapture the depreciation at ordinary income tax rates. You then pay the capital gains rate on the difference between the basis and the sales price (less costs). Or you can delay the tax through a like-kind exchange.

Common Depreciation Mistake

Another common mistake has much more potentially damaging consequences. Some taxpayers have made the mistake of not deducting depreciation on their investment property. If you’ve made this mistake, correct it immediately by filing to take the past depreciation with your current tax return. The IRS is going to assume you took it when you sold, and will recapture the depreciation that was previously taken (or that could have been taken), when you calculate your gain. You’ll have to pay tax on that recaptured depreciation even if you didn’t take it and there’s noting to recapture!