If an inherited rental property is subsequently improved by the beneficiary, how should the new improvements be added to the depreciation basis reported on Form 4562?
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When a beneficiary inherits rental property and subsequently makes improvements to it, the tax treatment of those improvements for depreciation purposes is governed by several key principles in the Internal Revenue Code and IRS guidance. Here’s how the improvements should be added to the depreciation basis and reported on Form 4562:
1. Establishing the Initial Basis of the Inherited Property
- The beneficiary’s basis in inherited property is generally the fair market value (FMV) at the date of the decedent’s death (or the alternate valuation date, if elected by the estate).
- This “stepped-up” basis becomes the starting point for depreciation if the property is used in a rental activity.
2. Treatment of Subsequent Improvements
- Improvements made by the beneficiary after inheritance are treated as separate assets for depreciation purposes.
- The cost of each improvement is added to the overall basis of the property, but for depreciation, each improvement is depreciated separately, starting from the date it is placed in service.
How to Determine the Basis for Improvements:
- The basis of each improvement is its cost, including all amounts paid for materials, labor, and related expenses (such as permits or architect fees).
- These costs are not added to the original building’s depreciable basis for purposes of depreciation calculations; instead, they are tracked and depreciated as new assets.
3. Depreciation Method and Recovery Period
- Each improvement is assigned a recovery period and depreciation method based on its nature:
- Structural improvements (e.g., a new roof, HVAC, or addition) are generally depreciated over 27.5 years (residential rental) or 39 years (nonresidential real property) using the straight-line method.
- Personal property (e.g., appliances, carpeting) or certain land improvements may have shorter recovery periods (5, 7, or 15 years) and may use accelerated methods.
- The depreciation for each improvement begins when it is placed in service (i.e., when it is ready and available for its intended use in the rental activity).
4. Reporting on Form 4562
- Each improvement should be listed as a separate asset on Form 4562, Part III.
- Enter a description of the improvement, the date placed in service, the cost (basis), the recovery period, the depreciation method, and the applicable convention (usually mid-month for real property, half-year or mid-quarter for personal property).
- The original inherited property and each subsequent improvement will have their own line entries, each with its own depreciation schedule.
- The annual depreciation deduction for each asset is calculated separately and then totaled for reporting on the tax return (e.g., Schedule E for rental property).
5. Special Considerations
- Bonus Depreciation and Section 179: Inherited property itself is not eligible for bonus depreciation or Section 179 expensing, but improvements made by the beneficiary may be eligible if they meet the requirements (e.g., have a recovery period of 20 years or less, are not required to be depreciated under ADS, and are placed in service after the inheritance).
- Cost Segregation: If a cost segregation study is performed, certain components of the improvement may be assigned shorter recovery periods, allowing for accelerated depreciation.
6. Example
Suppose a beneficiary inherits a rental house with a stepped-up basis of $500,000. The following year, they add a new roof for $20,000 and install new appliances for $5,000.
- The $500,000 basis is depreciated over 27.5 years (residential rental property).
- The $20,000 roof is depreciated as a separate asset over 27.5 years.
- The $5,000 appliances are depreciated as a separate asset over 5 years.
- Each asset is listed separately on Form 4562, with its own date placed in service, cost, recovery period, and method.
Summary: When a beneficiary improves inherited rental property, each improvement is treated as a new asset with its own cost basis and depreciation schedule. The improvement’s cost is not added to the original building’s depreciable basis for depreciation purposes, but is instead depreciated separately, starting when placed in service. Each improvement should be listed as a separate asset on Form 4562, with its own recovery period, method, and convention, and the annual depreciation for each is reported accordingly.
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