For rental properties inherited through an estate, what documentation is required to establish the depreciation basis on Form 4562?

To establish the depreciation basis for inherited rental property on Form 4562, the IRS requires specific documentation to substantiate the step-up in basis, the calculation of depreciable basis, and any subsequent adjustments. Here’s a comprehensive breakdown of the required documentation and the legal reasoning behind each requirement:

1. Documentation of Fair Market Value (FMV) at Date of Death

• Purpose: The FMV at the decedent’s date of death becomes the new basis for the inherited property under IRC §1014(a). This is the starting point for calculating depreciation.
• Required Documents:
• Appraisal Report: A professional, independent appraisal is the most reliable evidence. The IRS accepts appraisals, especially if used for estate tax filings.
• Comparable Sales or Broker Price Opinions (BPOs): If no formal appraisal was obtained, a comparative market analysis or multiple BPOs may be used, but these may carry less weight in an audit.
• Estate Tax Return (Form 706): If the property was reported on an estate tax return, the value listed there is generally accepted as the FMV.
• “The basis of property inherited from a decedent is generally the FMV at the date of the individual's death”; see also IRC §1014(a).

2. Proof of Ownership Transfer

• Purpose: To show the property was acquired from the decedent and qualifies for a step-up in basis.
• Required Documents:
• Probate Documents or Inheritance Papers: Such as a will, trust documents, or court orders.
• Deed or Title Transfer Records: Showing the property was transferred to the beneficiary or estate.
• Legal Reference: “The basis of property inherited from a decedent is generally one of the following: The FMV at the date of death, the FMV on the alternate valuation date, or the value under the special-use valuation method”.

3. Allocation of FMV Between Land and Building

• Purpose: Only the building (and certain improvements) is depreciable; land is not. The FMV must be allocated accordingly.
• Required Documents:
• Appraisal or Tax Assessment: Should specify the value of land versus improvements.
• Supporting Schedules: If the appraisal does not break out land and building, a reasonable allocation (e.g., based on local property tax assessments) should be documented.
• Legal Reference: “To calculate depreciation, the land value must be excluded, as only the building and eligible improvements qualify”.

4. Depreciation Schedules and Form 4562

• Purpose: To substantiate the annual depreciation deduction claimed.
• Required Documents:
• Form 4562: Used to initiate and track depreciation deductions.
• Depreciation Schedules: Show the calculation of annual depreciation, including the recovery period (27.5 years for residential, 39 years for commercial), method (straight-line for real property), and convention (mid-month).
• Supporting Calculations: Show how the depreciable basis was determined (FMV minus land value, plus any post-inheritance improvements).
• Legal Reference: “Form 4562 initiates depreciation deductions based on the adjusted basis”; see also IRS Publication 551 and 946.

5. Records of Capital Improvements and Adjustments

• Purpose: Capital improvements made after inheritance increase the property’s basis and must be depreciated separately.
• Required Documents:
• Receipts and Invoices: For renovations, additions, or other capital improvements.
• Improvement Logs: Detailing the nature, date, and cost of each improvement.
• Depreciation Schedules for Improvements: Each improvement may have a different recovery period (e.g., 15 years for land improvements).
• Legal Reference: “Capital improvements made after inheritance must be added to the property’s basis and depreciated separately”; see also IRS Publication 551.

6. Recordkeeping for Tax Filings and Future Sale

• Purpose: To substantiate the basis, depreciation, and gain or loss upon sale.
• Required Documents:
• All Above Documentation: Retain for at least three years after the tax return is filed, or indefinitely if the property is sold and a gain or loss is reported.
• Sale Documents: When the property is sold, records of the original step-up, improvements, and depreciation claimed are needed to calculate capital gain and depreciation recapture.
• Legal Reference: “The IRS requires taxpayers to retain records supporting the valuation, acquisition date, and any adjustments made to the property’s basis”.

7. Consistent Basis Reporting (Form 8971 and Schedule A, if applicable)

• Purpose: For estates required to file Form 706, beneficiaries may receive a Schedule A to Form 8971, which must be used to report a basis consistent with the estate tax value.
• Required Documents:
• Form 8971 and Schedule A: If received, this must be used as the initial basis for the inherited property.
• Legal Reference: “If you received a Schedule A to Form 8971... you will be required to report a basis consistent with the final estate tax value”.

8. Summary Table of Required Documentation

9. Conclusion

To establish the depreciation basis for inherited rental property on Form 4562, you must maintain and, if requested, provide documentation of the property’s FMV at the date of death (preferably via appraisal or estate tax return), proof of ownership transfer, allocation between land and building, records of capital improvements, depreciation schedules, and, if applicable, Form 8971/Schedule A. These records are essential for substantiating the step-up in basis, calculating allowable depreciation, and supporting future capital gain or loss calculations upon sale.