How are renovation costs treated for depreciation purposes if a residential rental unit is not placed back in service before the end of the year?
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Renovation costs for a residential rental unit are generally considered capital expenditures under IRC §263(a) and must be capitalized rather than deducted as current expenses. These capitalized costs are then depreciated over the appropriate recovery period once the property is placed in service for use in a trade or business or for the production of income.
1. Key Points on Depreciation Timing
1.1 Placed in Service Requirement:
Depreciation begins only when the property (or the improvement) is "placed in service," meaning it is ready and available for its specific use in the rental activity, not merely when the renovation is completed or when the costs are incurred.
1.2 If Not Placed in Service by Year-End:
If the residential rental unit is not placed back in service before the end of the year (i.e., it is not ready and available for rent), you cannot begin depreciating the renovation costs in that year. The costs remain capitalized, and depreciation starts in the year the property is actually placed in service.
1.3 Definition of Placed in Service:
According to Treasury Regulation §1.168(i)-4(b)(1), property is considered placed in service when it is ready and available for a specific use in a trade or business or for the production of income. For a rental property, this means the unit must be ready and available to rent, not just under renovation or repair.
1.4 Treatment of Renovation Costs:
- Renovation costs that improve, better, or restore the property must be capitalized and treated as a separate asset for depreciation purposes.
- The recovery period for improvements to residential rental property is generally 27.5 years under the General Depreciation System (GDS) using the straight-line method and the mid-month convention.
- The depreciation for the improvement begins when the improvement is placed in service, which is when the rental unit is ready and available for rent after the renovation is complete.
1.5 Example:
If you renovate a rental unit in 2025 but do not complete the renovations or make the unit available for rent until 2026, you cannot claim any depreciation deduction for the renovation costs on your 2025 tax return. Depreciation for those costs will begin in 2026, the year the unit is placed back in service.
Summary: Renovation costs for a residential rental unit that is not placed back in service before the end of the year must be capitalized. Depreciation of those costs does not begin until the year the unit is ready and available for rent (i.e., placed in service). No depreciation deduction is allowed for those costs in any year before the property is placed in service.
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