Income tax 2022-2023, depreciation and rental property tax software example, let's do some wealth preservation with some tax preparation. Here we are in our example Form 1040 populated with LASERT tax software. You don't need tax software to follow along, but it's a great tool to run scenarios with. You can also get access to the Form 1040 related forms and schedules at the IRS website, irs.gov, irs.gov. We have our starting point single filer Mr. Anderson 90210 Beverly Hales living in and we're going to say that they have just the rental property. So we can focus just on the impact of the rental property coming from the Schedule E, which is formatted in essence as an income statement. For the purposes of this problem, we're going to say it's 100% rental property. It's not vacation property. We're not personally using it or living in it so that we can just focus on depreciation here. We've got starting point 120,000 of income, 20,000 of expenses to give us that 100,000 net income, which is flowing into Schedule 1, which is flowing into the first page of the Form 1040 standard deduction 12,950-87,050 taxable income. Alright, back to the Schedule E. We're focused on the depreciation. Now, support accounting instruction by clicking the link below, giving you a free month membership to all of the content on our website broken out by category further broken out by course. Each course then organized in a logical, reasonable fashion, making it much more easy to find what you need than can be done on a YouTube page. We also include added resources such as Excel practice problems, PDF files and more like QuickBooks backup files when applicable. So once again, click the link below for a free month membership to our website and all the content on it. We think about depreciation. The first thing probably that comes to mind is the building itself. That's going to have the biggest impact typically for depreciation in a rental property situation. And we have to think about that primarily when we first purchased the building or put it into place, because that's when we have to figure out what the basis is and so on and pick the proper method. And then of course the software might help us out from that point forward once we've properly put it on the books. And then there could be other depreciation for improvements and things like that, which we have to be careful from a bookkeeping standpoint to make sure that we pick out those items that need to be improvements as opposed to repairs. We might scan the repairs line item here to see if there are any like big items in there that look like they possibly should be categorized as improvements instead of the repairs. Alright, so let's first think about the property itself. So remember when we get the property, there's a couple ways that that might happen. We might just purchase the rental property, in which case it's the most straightforward type of situation, because the purchase price adjusted for anything we needed to get it in place for service, increasing by those items is basically the cost or basis. But we could inherit the property, in which case we've got to think about, okay, what's going to be the cost? Is it the fair market value or at the time of inheritance or the disease of the, or we could get a gift of the property, which again gets kind of messy because then the basis, you know, it's kind of linked to the basis of the prior owner or something like that. Did we convert the property from our personal use to rental use, in which case you would think, okay, does it need to be fair market value or the cost? And if the fair market value is higher than the cost, you would think that it would have to be remaining the cost when it was personal property, otherwise you would have that step up in basis kind of situation. And then you have the issue of breaking out between the building and the land. So let's think about that concept real quick. Let's say we purchase something, we purchase the building for $200,000, building and land, the property, and then we need to break it out between land and building. And the question is, well, how do we do that? Because I'm going to pull this down, we just paid $200,000 for it. So one way you might do it is to take a look at the prior tax assessment, the prior tax assessment for property taxes, and let's say the prior time when they assessed it, the total amount was $160,000. $160,000 for the total. And they broke out between land and building on the tax assessment, $136,000 for, let's say this is, let's go house and then land. And then the land was $24,000 for a total total of the $160,000. So we can use basically those percentages. We can't use those same numbers because obviously it was at $160,000, but we can use like a ratio and I could say, okay, let's take this divided by this, make that a percent, and that's 15% versus this divided by this, make that a percent, 85% if I sum that up, it's 100%. So that would be a common way that we might deal with this problem and say, okay, I'm just going to do the same thing here, $200,000 times the 85%, and then I'm going to take the $200,000 times the 15%, breaking out the current cost that I paid for it, $170,000, $30,000 house to land. This is the depreciable component. This is the non-depreciable component. So let's use that and then populate this into our depreciation schedule. So different softwares will look different, but the concept will be the same. You've got your depreciation schedules, and I'm going to say that we've got the house, and I probably should put the address, but I'm just going to put, you want to be as descriptive as possible, but I'm just going to go generic here and just say the house or the building is going to go to the schedule E and the category is going to be a building, date placed in service. Let's say it was placed in service on 02-03-22. So we're going to be using the method that we're going to be using because it's a building will be a mid-month convention, so it'll assume it was purchased in the middle of February. The cost, I'm going to say, and remember when we calculate the cost to get to that 200,000, we've got to take into consider whether the stuff that was necessary in order to make the purchase happened, including all the costs to go through escrow and stuff might be included in the purchase price as opposed to being expensed at that point in time, but we're going to say 170,000. We don't have any 179 for it's going to be, the property is going to be 27.5 years straight line residential rental building and so there we have it and then the other is just land. So I can put on the books even though it's not going to depreciate. Schedule E category will be now land and 020322 and that's for the, what did we say, 30,000. 30,000 to get to the 200,000. It's useful to put both those on the books even though the land is not going to be depreciated and we don't have a balance sheet on our books. So why do we need it? Because it's useful to tie into of course the purchase price. So in the future when we sell or something like that, we can see what happened. The building versus the land can tie into the, you know, the purchase price. There's not going to be any depreciation on the land. So land, no depreciation and let's see the result. So that pulls into our schedule E. We see the populated here. If I go into the depreciate, we don't have a balance sheet, but we'll typically have these depreciation schedules to help us to kind of see what is happening. And now we've got the building versus the land. And if we kind of analyze this, we say, okay, it's a house. The date was acquired here. This is the depreciate 170,000 is the depreciable component. And we're using SL straight line mid month MM 27.5. The life, the years it's going to depreciate over. And then the rate from the tables using the table method is point is that rate to give us the 5409. In other words, if I took the 170,000 times the 0.03182, there we have it. Now let's actually try to calculate it using a straight line mid month convention to get a better understanding of what is happening. So it's a straight line method. So the start is pretty straightforward. 170,000 divided by the number of years, 27.5. That would be the amount if it was for an entire year, but it wasn't. And we bought it in the middle or in the beginning of February, but it's a mid month convention. So we assume that we bought it, you know, at the middle of February. So if there's 12 months in the year, we've got 12 months minus like a month and a half. So 12 months, like 10 and a half months, right? Because because we only had it for a month and a half. So we're going to say, let's say divided by 12. And that would be the amount per month times 10 and a half months times 10.5. And that gets us about the same number. So that's what's happening. Now this one's a little bit easier to project into the future than if we were using a double declining method, because we would expect the second month to be a full year straight line method, which was 170,000 divided by 27.5. And we can see if I go to year two, year two is at that 6181. So that's pretty easy to kind of project out into the future easier than, you know, the double declining methods to do that. There's no depreciation on the land. Now note that if you're taking out a new client or something and they have rental property, this schedule might not always be attached to the return. You're going to need the schedule so that you can get the rental property on the books correctly. So if you have rental property, I would highly recommend that if you have a new client, what you would like to do is populate the stuff into the system as of the prior year so that you can then roll it over into the current year and make sure your depreciation schedules are populated properly and match the prior year and so that they should roll over to the current year easily. Now, obviously the depreciation will continue until all of the 170,000 has been consumed within depreciation. We've allocated it all out. We've got a tax benefit from it because we got a deduction for the depreciation expense over the 27.5 years. And after that point in time, then if I go to like 2023, you can see part of it has been depreciated in the prior year. That means the basis in the property from a balance sheet standpoint is 170,000 minus the 5409 minus the 6181. And that's the depreciated part that has not yet been depreciated that represents current tax benefit into the future, that we're going to be getting into the future either in the form of depreciation or if we dispose of the property, then when we sell it, we're going to take the sales price minus this basically adjusted basis in the property, including also including the land. So in other words, we would like to get the expenses as soon as possible. So we would like to write off the whole 200,000 this year oftentimes if we could, but they won't let us. We have to put it on the books as an asset, run the depreciation schedules. Then we would like to have the depreciation life as short as possible so I can get the depreciation as early and I'd like to have an accelerated depreciation method if we could, but in general, they won't let us with the land. We have to put it pretty long life, 27.5 and then the straight line method. Now the 170,000 higher basis is usually good. We want the high basis for, because that represents tax benefit into the future. The lower the basis goes, it's good when we lower it because we're getting a tax benefit. We're lower in the basis, getting a tax benefit, but the lower the basis is when I sell it, that means that we're going to have a gain more likely to have a gain. Gains are bad for taxes because it's income or we're likely to have less of a loss. Losses are actually good for taxes because we might be able to reduce other income with the loss. So that's the general idea. Now the other thing that's common is that we might have improvements. If we have improvements in the property, you might say, hey, I would like to just expense them like as repairs, like the common roof example, where I'd say, hey, let me just expense the whole roof that I put in place right here. But then if you replace the whole roof, they're going to say, well, no, it's an improvement. Well, if it's an improvement, then I've got to put it on the books possibly as an asset. Ascent acquisition, enemy agent disposal. And if it's an improvement, I might have to depreciate it over the same, in essence, useful life as if the real estate was put in place at this point in time, the 27.5 years. Now note that some situations could come up if you're putting in stuff like a heating system or something like that and you're like, well, maybe if it's not permanently attached to the home or something like that, maybe I can call it not an improvement. And if I can't just call it a repair and depreciate it, I would like to depreciate it over five or seven years as opposed to 27.5 years. That would be more beneficial. So you run into these kind of problems as well. I would like to record it as a repair so I can get the expense now. If they won't let me record it as a repair, do I have to depreciate it over 27.5 years straight line method? Or can I somehow get it categorized as five year, seven year property so I can have an accelerated depreciation method at least or even better take a 179 deduction or a special depreciation allowing me to take it sooner would be the idea. But if it's a standard improvement, we'd say, and usually the improvements are going to happen not in the same year that we purchased the home. But let's say we had an improvement. So improvements and again, you probably want to be a lot more specific. You would on your descriptions. So you know exactly what the improvement was so that at a future time when you sell the home or something, you can figure out your adjusted basis for the sales price, which will typically be the house, the land, the improvements. And you can back up those improvements because you can go and find, you know, the documentation of the improvements that were put in place. So we're going to say this is going to be going to schedule E as well. This is going to be for improvements. So I'm going to say it was 11, 15, 22, 15,000. And I'm going to use that maker's 27.5 year straight line, which is the same method as with the house. So now if I pull back on over, we've got that populating here. If I go to my 2,022 depreciation schedules, we now have another category with the improvements. So the improvements here calculating another $68. You can see how much the improvement is reduced because the 15,000 a fairly significant dollar amount if I got to expense it. And the current year would be $15,000 versus if I have to expense it over 27.5 years, significantly less $68 over 27.5 years, which will still add up to the 15,000. But I have to wait a lot longer to do that versus if I was able to categorize it somewhere else or populate it in 179 deduction or a special, where I would get more of it upfront in those cases or if I can populate it somewhere other than the 27.5 year property, like a five year or seven year, I would get an accelerated method possibly, double declining or something like that and be able to depreciate it not over 27.5 years. So you can see the incentives from a taxpayer perspective. I would like to not have to capitalize it, not put it on the books as an asset, take the 15,000 as an expense, pay the taxpayers or something if I could or get a 179 deduction or special, which would basically have a similar effect or have a lower life and an accelerated appreciation, double declining if I could, or seven or five years and rather than having a longer life with a straight line kind of method would be the general thought process. But obviously the tax code is going to restrict us. Remember that we might have had a loan on the property, if I had a loan on the property and had points on the loan. So if I go over here, I would expect if I had the rental property that I would have a loan on it and you would expect for me to get a statement for the interest statement. So I would have mortgage interest not going to schedule A, but rather being an expense here. So let's say we had interest, mortgage interest and let's say it was, it was, you know, 13,000 or something like that. But we might also have points that we discussed a little bit in a prior presentation, which are kind of, we can think of them as basically the advanced payment of interest. So we should get to deduct the interest then, but the fact that it's advanced, the IRS doesn't like those advanced payments. They think you're taking advantage of taking the deduction sooner rather than later. So we might have to put the points on the books, which again really only happens when you first buy the property or something or take out the loan. So you might have to depreciate basically points. And the general idea with the points would be that you're, let's take, let's go to the depreciation schedule. If that was to happen, you're going to say, all right, got to depreciate the points. So let's add another one. And then points you'd probably want to be, you would want to be quite specific on the loan and possibly the last four digits of the loan number. So you know which points you're talking about where it's tying to. So if you sell the property or refinance, you can properly deal with the points at that point in time. And so we're going to say this is going to be, so let's say we're going to amortize it and we're going to say that was $1,000 in points. Now there was a calculation we can look at and say, well, were the points significant or not? If the points are fairly small, fairly insignificant, then we can basically just use a straight line method to allocate. So in other words, the question is, what method am I going to use for the points? Well, I'm not going to tie it to the property. It's not going to be that 27.5 years. I'm going to tie it to the loan. And then you'll note that if you were to be really accurate about it, when you look at the loan payments, the amount that's allocated between principal and interest actually changes. So if we were to be really accurate with the points, we would have to do a calculation to have a different amount of the points being amortized each period. But if the amount is insignificant, maybe we could do the easy thing, which is to just do the straight line method over the life of the loan. So let's say this is a 15 year loan as opposed to a 30 year loan. We may be able to just say, okay, I'd like to just do a straight line method. And then I'm just going to populate over 15 years. So if I go back on over, that's another item that we might have included. So now we've got the amortization of the points that we're dealing with. And again, it's a fairly small amount of 61. It would be even smaller if it was a 30 year loan. I wanted to make it 15. So it doesn't look like we're amortizing it over like the 27.5 years similar to the building, but rather according to the life of the loan. All right, and so the next thing that we might have depreciation related to, so if I go back to my schedule E, are things like equipment or stuff like that, that's not improvements, but we're going to put them in there as three year property, five year property, seven year property. Again, from our standpoint, I can allocate something as repairs. More repairs. I would like to do that. If not, I would like to not call it improvements, but rather call it three, five or seven year property if I'm able to do that because I'm depreciating over a shorter life, getting the expense sooner and possibly able to use a 179 special deduction and or the accelerated depreciation methods. So if I do that, I'll go over and say that we had something like equipment or something that we're using for our rental business or whatever. It's going to be going to three and then we're going to say this is going to be machinery and equipment, let's say, and we're going to say, let's say this is going in as of 707.1522 and let's say that it is 8,000 for the equipment. So now I'm going to say, I'm going to say this is five year property. So if it's five year property, we got to be careful with the auto limits. I'm not going to choose the straight line. Usually I'm going to choose maker's five year property because that gives me a double declining. I could opt to use a straight line if I wanted to, but usually you would want the maximum default because that's going to give you the double declining method. Now also note that if I just do that and I pull over here and I go into my depreciation schedules and let's see the full schedule. So now we've got amortization, building improvements, land, and we have page number. Where's my equipment and the equipment, there it is, the scroll down is quite slow. So we've got the equipment and by default it took the 179 special so it allows us to depreciate all of it up front. Great, usually that's quite good oftentimes. So if you can get the special depreciation or 179, that's usually beneficial. If you can't do that, then you might be able to take the 179 deduction. So if I was to say instead of the special, I'm going to take the 179, 8000 on the 179, if I'm able to do that, you have a similar kind of scenario which in essence allows you to kind of expense it up front, basically allows you to just expense it. Why didn't you just let me, why don't you just let me call it repairs or expense or machinery expense or whatever if you're going to let me do that. So you can get into the weeds and nuances of the 179 and the special depreciation but you would think as time passes, those are more political things that are trying to manipulate the economy and make people look good and stuff like that. So you would think that those may come and go but then the underlying depreciation will remain. So let's remove that just to look at the maker's depreciation and see it that way. So I've now elected and basically the way it works is that the 179 deduction you take that and then if you don't take that it'll default to the special deduction and then if you elect not to take the special deduction which you wouldn't normally do unless you expect future years to have more revenue than the current year in which case you're going to say, hey look I'd rather get the benefit in future years when my tax rates will be higher due to the progressive tax system but then we can see we get this double declining so you can compare this. This one up here is the straight line mid-month convention 27 and a half years. This is a 200 dB double declining method in essence HW half year convention that we have for five years and so if I was to calculate that then it would be something like, okay 8,000 divided by 5 that would be the straight line rate it matches but this is for six months this is for a full year so if I was to say okay if I divide this by the 8,000 the rate is 2% which I can also get by taking 1 over 5 double the rate times 2 because we're doubling it 40% times 8,000 that would be the amount for the full year if it was for 12 months rather than 6 months then I divide it by 2 to get the 6 months that's where that 1,006 is it looks the same as straight line but it's not and we could see in year 2 what we would have to do is take the 8,000 minus the 1,600 is that times the 0.4 which is 2,5 and so we could see that calculation over here for year 2 there's the 2,5,6,0 in year 2 so it's a little bit of a much messier calculation than the straight line although the half year is a little bit smoother than the mid month convention now the other common issue that you have is the same kind of issue with the schedule C and that's going to be the auto and travel so the question there is are you going to be using a mileage method or are you going to be using a direct method if you use a direct method then you have some limitations for the auto often times because they don't want to allow you as big a deduction up front with the auto limits so if you're using auto then 3 it's going to be automobile it was an 0,2,032 let's say it was 20,000 auto and we're going to say then we've got the straight line makers 5 year auto limits that's the main thing that you want to note here that we have the auto limits in place so I don't want to go into them in a lot of detail but you can imagine the same kind of problems with the auto that we have with the schedule C which is that do I want to use the percentage method do I want to use the direct method if I use the direct method I've got the depreciation and I still have to think about do I need to allocate it between the rental and the personal kind of situation also which of those two methods are going to be most beneficial for me to take and that will depend on not just the current year it will be the direct method but if you use the direct method and the current year could lock you into using the direct method because the iris is skeptical of you taking more depreciation in period one and then switching to the mileage method because then you'd be taking a big lump sum up front and then you'd get the added benefit of the mileage method which is supposed to even everything out so that's where you're a little bit limited as to whether or not which method would be better, the direct method or the mileage method