Determining your depreciation deduction for your residential rental property starts with getting the depreciation basis correct. Getting basis wrong is the source of many military landlord depreciation errors.

Many military landlord rentals are converted properties, converted from a primary residence to a rental. In these situations your basis will be the LOWER of either your adjusted basis or Fair Market Value at time of conversion. We’ll focus on adjusted basis.

Initially, the depreciation basis will match your initial cost basis-minus the value of land, as that is not depreciable. The total cost basis does not actually equal sales price in 99.99% plus of cases. This is because SOME closing costs are included in the cost basis and potentially other reasons. SOME of what we call closing costs are not a tax deduction at all. SOME might be deductions in some cases. Loan costs do not go into the depreciation basis of a property. IF the property was bought as a rental property loan costs are amortized over the life of the loan, which is a different topic. IRS Publication 523 does an okay job explaining closing costs and their impact on basis, although not perfect.

Once the initial cost basis is determined, land value has to be subtracted out. There is no IRS accepted thumb rule for this – 20% or 15% or anything else. If anyone tells you this, ask for the official source document. They won’t be able to provide it, because it doesn’t exist. We’ll briefly mention the two most common methods. For both of these methods what you are usually getting from them is a ratio of land vs improvements (building) basis. This is because the numbers for land value and improvement value you get from these methods usually don’t equal your total calculated basis. Once you have the ratios, you apply them to your total calculated basis to allocate land basis and improvement (building) basis. The first method is to use the official purchase appraisal done by an appraiser IF it has site or land value included. Unfortunately in many cases appraisals don’t have that. Often lenders don’t require the cost approach that will generate that value. The second method is the county/city tax assessment method. You look at the assessment for the year of purchase. They often break out land and improvement values. You use the ratio that generates and apply it to your actual basis numbers and you allocate your basis. A couple of things to note here. Often the county/city will indicate that the assessment may not actually be real value and should not be relied on for any basis calculation. The IRS and court precedent indicate that it is okay to use these assessment numbers if no better data exists. If no better exists, so if you have a valid appraisal that has land value in it and you have the assessment, you are supposed to use the appraisal even if it is worse for you to do so.

But we aren’t done yet. Let’s say you do some improvements or added assets before putting the property into service as a rental. We are talking improvements, not repairs or general maintenance done while you live in the property. As a side note improvements vs repairs and maintenance, AND when to depreciate and when not to depreciate those things is another area of common errors which I won’t discuss at this time.
So the improvements. Let’s say you replace a roof for $10,000 and that is done before the property is in service as a rental. Then that $10,000 is added to your initial improvement or building basis to be depreciated once the property is in service. This “adding” needs to be done after the land to building allocation of depreciation basis, since the roof only impacts the building.

Disclaimer: This explanation of depreciation basis is incomplete and should not be solely relied on for tax preparation or planning. Due diligence is required to properly understand the tax code and to properly prepare tax returns. That requires much more than reading a few paragraphs via the internet. Your specific tax situation may differ from those meant to be addressed above.