Depreciating Indian Rental Property on a US Tax Return

As a US person, you clearly know how US taxes differ from Indian taxes. Well, you can also see this when you report your Indian rental property on Schedule E. The US applies a different depreciation method than India, which has its own rules and timeline. Given this, when depreciating Indian rental property on a US tax return, you generally need to follow the Alternative Depreciation System (ADS) because tangible property used predominantly outside the United States is subject to ADS under U.S. tax rules.

For foreign residential rental property, the ADS generally applies when the property is used predominantly outside the United States. It follows a straight-line method that generally deducts an equal amount over the applicable recovery period, subject to the applicable conventions. For NRIs who are liable to pay tax on the rental income in India and are also US persons, this creates a lot of confusion and issues.

Further, to help you out and provide a clear idea, this blog explains depreciation for Indian rental property on a US tax return. So read on and gather all the details.

Key Takeaways

• Tangible property used predominantly outside the United States generally must be depreciated under the ADS. For foreign residential rental property placed in service after 2017, the ADS recovery period is generally 30 years. The ADS recovery period for nonresidential real property is generally 40 years.

• In the US, whether the property is domestic or foreign, depreciation applies only to the depreciable portion of the property, not to land.

• Depreciation generally begins when the property is placed in service, meaning when it is ready and available for its intended business or income-producing use, rather than simply when you purchase it. For instance, if you bought a property to rent out, depreciation generally begins when the property is placed in service for rental use.

• Applying the appropriate depreciation method can reduce taxable rental income, subject to applicable limitations, and support accurate U.S. tax reporting.

• Depreciation reduces the adjusted basis of your foreign property. This can increase your taxable gain when you sell the foreign property because the gain is generally calculated using the adjusted basis. The depreciation-related portion of the gain may also be subject to applicable U.S. depreciation recapture rules.

Can You Depreciate Indian Rental Property on a US Tax Return?

This entirely depends on your tax status in the US and whether the property is depreciable under US tax rules. Given this, if you are a US person (citizen, green card holder, or resident alien) and own an Indian rental property that is used for rental or another income-producing purpose, you generally need to calculate depreciation under U.S. tax rules. The depreciation rules can still apply when you are a US person living abroad.

In simple terms, as a US person holding depreciable foreign rental property, you generally need to apply U.S. depreciation rules regardless of where you live. Further, for a detailed overview of your Indian rental property in the US, read our guide on US Tax Treatment of Rental Income from Indian property.

Now, moving ahead, let's learn how Indian rental property is depreciated under US tax rules.

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How Is Indian Rental Property Depreciated Under US Tax Rules?

For Indian rental property, the Alternative Depreciation System (ADS) generally applies because tangible property used predominantly outside the United States is subject to ADS. The ADS method generally uses the straight-line method, which provides equal annual deductions except for applicable first- and last-year conventions. Further, the foreign property recovery period under ADS depends on the type and date the property was placed in service.

ADS Recovery Period for Indian Rental Property

The applicable recovery period can depend on when the property was placed in service and the specific classification of the property. The table above reflects the general ADS treatment; specific facts may result in different rules.

Key Point to Consider: The US depreciation system varies from India's, so when reporting your Indian rental income, use the applicable US depreciation rules rather than the Indian depreciation amount. Property required to be depreciated under ADS is not eligible for the special depreciation allowance. Section 179 generally does not apply to residential rental buildings; however, certain separate items of tangible personal property may have different rules and should be evaluated separately.

This was all about how Indian rental property depreciates under US tax rules. Moving further, let's learn how to calculate the ADS basis of Indian rental property.

How Do You Calculate the Depreciable Basis of Indian Rental Property?

Here is how to calculate the depreciation on Indian rental property to report on your US tax return:

• Step 1: Determine the depreciable basis of the property under US tax rules. This generally includes the property's cost and qualifying capitalized costs, but the calculation must be reviewed carefully because not every closing cost is added to depreciable basis.

  • Purchasing cost

  • Qualifying capitalized closing costs

  • Capital improvements

  • Minus

  • Land Value (as depreciation is not applied to land)

• Step 2: Determine the applicable recovery period based on the property type and the date it was placed in service. For instance, for qualifying residential rental property placed in service after 2017, the ADS recovery period is generally 30 years.

  • Annual depreciation is generally calculated using the applicable depreciation basis and recovery period, subject to the applicable depreciation convention.

• Step 3: Convert the property's basis and relevant rental income and expenses from Indian rupees to US dollars using the appropriate exchange-rate rules for the relevant tax item or transaction.

Let's look at this with an example.

For instance, you have an Indian rental property valued at $450,000, and the land value on which the property stands is $90,000. Here, assuming the $450,000 represents the appropriate U.S. tax basis and the $90,000 represents the land portion, the depreciation basis will be $360,000 ($450,000 - $90,000). Now, calculating the Annual depreciation using the formula, i.e.,

• Annual depreciation = Depreciation basis ÷ 30 years

• Annual depreciation = $360,000 ÷ 30 years

• Annual depreciation = $12,000

This $12,000 represents the approximate full-year straight-line depreciation before applying the applicable convention. Because residential rental property uses the mid-month convention, the actual first-year deduction depends on the month the property is placed in service. The second through later full years can generally be close to the full-year amount, subject to the applicable depreciation tables.

For example, if qualifying residential rental property is placed in service after 2017, the IRS depreciation table provides a different first-year percentage depending on the month placed in service. Therefore, taxpayers should use the applicable IRS depreciation table rather than simply dividing the basis by 30 for every tax year.

The depreciation deduction is generally reported on Schedule E, Part I, and Form 4562 is completed and attached when required.

Further, if you are facing issues converting your Indian rental income to dollars, read our blog on "How to Convert Indian Property Basis from INR to USD?" Now, moving ahead, let's look at when ADS applies.

When Does Depreciation Start for Indian Rental Property?

Depreciation starts on the Indian rental property when you place it in service, meaning when it is ready and available for rental or another income-producing use, not simply when you purchase it. Depreciation generally ends when you have recovered the depreciable basis or when you dispose of the property or otherwise stop using it for an income-producing purpose, subject to the applicable rules.

For residential rental property, the mid-month convention generally applies, so depreciation is determined using the applicable convention for the month the property is placed in service and the month it is disposed of.

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So, in simple terms, the ADS depreciation period begins when the property is placed in service for rental use, not merely when you purchase it. Moving further, let's look at how improvements, furniture, and appliances are depreciated.

How Are Improvements, Furniture and Appliances Depreciated?

Depreciation is not applied to all items linked with your foreign rental income in the same way. The building and qualifying capital improvements are generally depreciated over their applicable recovery periods. Furniture and appliances can also be depreciable assets, but they may have different recovery periods and depreciation rules.

This includes:

• The depreciable structure of the building (such as floors, walls, and foundation)

• Additions or extensions to the building

• Major structural improvements or a new roof

• Qualifying permanent improvements or installations made to the property

Further, as stated earlier, land on which the property sits, regardless of its value, is not depreciable. In addition, furniture and appliances, such as a bed, chair, or fridge, may be depreciable if they are used in the rental activity and otherwise qualify under U.S. tax rules. Routine repairs and maintenance are generally deductible expenses rather than depreciable improvements, provided they qualify as current expenses.

There is a huge difference between improvements and repairs; you cannot automatically classify repairs as capital improvements. For a detailed overview of current expenses, read our blog on "What Expenses You Can Deduct for Indian Rental Property on a US Tax Return?"

India vs. US Depreciation for Indian Rental Property

Therefore, the depreciation amount claimed in India should not simply be copied to the U.S. tax return. The U.S. depreciation calculation must be performed separately under applicable U.S. federal tax rules.

Now, moving ahead, let's see how you report ADS on Form 4562 and Schedule E.

How Do You Report Depreciation on Form 4562 and Schedule E?

To report your depreciation on Form 4562 and Schedule E, Part I, you need to first calculate the applicable depreciation amount using the above-stated method and the appropriate recovery period and convention.

Form 4562 is generally used to report depreciation and amortization and to provide information about the property being depreciated. Schedule E, Part I, is generally used to report rental real estate income and expenses, including the applicable depreciation deduction.

Further, for more detail on filling out Schedule E, check out our blog on "How to Report Indian Rental Property on Schedule E?" Moving to the next section, let's see what happens if you did not apply the correct depreciation method to Indian rental property on a US tax return in previous years.

What If You Did Not Claim Depreciation in Previous Years?

If you did not claim depreciation on your Indian rental property on your US tax returns in previous years, you may face issues during a property sale. This is because the US generally determines your adjusted basis using depreciation allowed or allowable, which can affect your gain or loss on sale. In simple terms, depreciation that was allowable may reduce your basis even if you did not actually claim the full deduction.

Further, if you used an impermissible depreciation method or otherwise need to change your accounting method for depreciation, you may need to file Form 3115, Application for Change in Accounting Method, depending on the circumstances and applicable IRS procedures. In some cases, a section 481(a) adjustment may allow previously unclaimed depreciation to be taken into account.

So, if you did not claim depreciation in previous years, do not automatically assume that filing Form 3115 is always the solution. The appropriate correction depends on why depreciation was not claimed, how many returns were filed, the depreciation method used, and the applicable IRS procedures.

How Does Depreciation Affect Rental Losses and the Future Sale?

Depreciation affects rental losses and the future sale differently. Here is how it works:

• Rental Loss: From your gross foreign rental income, depreciation and eligible expenses are deducted. Given this, if the resulting rental expenses and depreciation exceed rental income, it may result in a loss. However, there are restrictions and rules under the passive activity loss rules and other applicable provisions that may limit how much of the loss can be used. In short, depreciation may reduce taxable rental income, but the resulting loss may be subject to applicable limitations.

• Capital Gains: Depreciation reduces the property's adjusted basis. This can increase the gain recognized on a later sale. The depreciation-related portion of the gain may be subject to the applicable U.S. depreciation recapture rules.

This is how depreciation affects rental losses and the future sale. Moving ahead, let's look at the common mistakes US persons should avoid when reporting it in Schedule E.

Common Depreciation Mistakes US Persons Should Avoid

Here are some common mistakes that US persons should avoid when depreciating Indian rental property on a US tax return:

• Not applying the correct depreciation method when reporting Indian rental property income in Schedule E, Part I.

• Using the Indian depreciation amount instead of calculating depreciation under applicable U.S. tax rules.

• Applying depreciation to land and routine expenses.

• Instead of using the appropriate U.S. tax basis, using the current market value of the property for calculating depreciation.

• Using the purchase date in the depreciation calculation instead of when the property was placed in service.

• Not adding qualifying capital improvements when calculating depreciation.

• Incorrectly treating furniture, appliances, repairs, or other expenses as part of the building's depreciation basis instead of applying the appropriate U.S. tax treatment.

• Assuming that the 30-year ADS recovery period applies to every foreign property without checking the property's classification and placed-in-service date.

• Assuming that every missed depreciation claim automatically requires Form 3115 without reviewing the circumstances and applicable IRS procedures.

These are some of the key mistakes that you should avoid when depreciating Indian rental property on a US tax return.

Final Thoughts

Lastly, depreciating Indian rental property on your US tax return is a vital aspect of reporting your rental income. The Alternative Depreciation System (ADS) generally applies to tangible property used predominantly outside the United States, including qualifying Indian rental property reported on a U.S. tax return. For qualifying residential rental property placed in service after 2017, the ADS recovery period is generally 30 years, while nonresidential real property generally has a 40-year ADS recovery period. Depreciation generally begins when the property is placed in service, not simply when it is purchased.

Further, if you are facing issues in calculating foreign rental property depreciation on a US tax return, connect with Savetaxs. We have a team of cross-border tax experts who help you determine US depreciation for property in India, correctly report your rental income, and ensure compliance with applicable US tax laws.