Rental property depreciation allowance (or cost recovery) forms the basis for a major part of the tax shelter benefits real estate investors seek when investing in income property.
As a result, most of those making real estate investments are undoubtedly familiar with the term and its benefits. Yet they may not understand how the “mid-month convention” derived by the tax code is computed.
So in this article we’ll take a look at depreciation allowance and the mid-month convention.
According to the current tax code, those who purchase income property can take a depreciation deduction on the real property (the improvements, not the land) according to its useful life as prescribed by the tax code.
- Residential rental property (27.5 years)
- Non-residential rental property (39.0 years)
This means the annual depreciation for an apartment building would be about 3.6% of the cost of improvements. The annual deduction for non-residential property would be about 2.6%.
The depreciation allowance starts from the month the asset is placed into service (usually when title is taken) for use in a trade or business or for income production until whatever month the asset is disposed of. For example, if an investor takes title to a rental property in 1998 and sells it in 2012, then he would be eligible to take an annual deduction for depreciation for each of those years according to the appropriate depreciation schedule for the property.
Of course that’s fairly straightforward for the years the investor holds the property for a full twelve months (e.g., 1999 through 2011). But what about the year of purchase and then sale? Those would not typically equal a full twelve months ownership because both a purchase and sale would occur “inside” the month (resulting only in a portion of the month; not the full month).
To deal with this, the tax code also incorporates what is called a mid-month convention to whatever month you place the asset into service and whatever month you dispose of it. Here’s the idea.
Rather than use the actual day of the month to begin or end the depreciation deduction allowance, the IRS simply assumes that the property is placed in service in the middle of the month when it was acquired and disposed of in the middle of the month when it is sold.
In other words, investors are entitled to one-half month’s depreciation in the month the income property was placed into service (regardless of the actual number of days in service for that calendar month), and one-half month’s depreciation in the month of disposition (regardless of the actual date of disposition).
For example, if the real estate investor procures the rental property on March 3, he would be given half a month’s credit for the month of March along with the remaining nine months in that year. He would be entitled to a depreciation allowance of nine and one-half months in 1998 (the year of purchase). Likewise, if he transferred title to the rental property on August 20, then he would be entitled to claim depreciation for half the month of August along with the previous seven months he held the property in 2012 (the year of sale).
So You Know
ProAPOD real estate investment software solutions Investor 8 and Executive 10 each apply the mid-month convention automatically for the depreciation allowance calculation.