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When you own a capital asset, the Internal Revenue Service lets you write down its value for a number of years through depreciation. Depreciation simulates the gradual loss of value as a car, computer, furnace or building ages. The benefit of depreciation is that, because you don't spend money every year on it, it effectively shelters that portion of your income from taxes. The downside is that when you make major purchases, like buying a furnace, you have to spend the money upfront but realize the tax write-off over a set number of years.
Many landlords consider replacing a furnace as a repair to the building. In the Internal Revenue Service's eyes, though, it's an improvement. The difference is significant, as you can write off the entire cost of a repair in the year you pay for it, while you have to depreciate improvements. The IRS defines an improvement as something that betters, adapts or restores a property. Because installing a new furnace is a betterment, you'll have to treat it as an improvement and depreciate it.
Residential rental properties are depreciated over 27.5 years. Commercial rentals are depreciated over 39 years. Land, however, isn't depreciated at all, so you'll need to subtract its value from your depreciable basis. Improvements you make to your property are assigned the same life as the property, so if you put a furnace in a rental home, it'll have a 27.5 year lease starting from the date you install it.
The 27.5 year life that the IRS assigns to a furnace when it's installed in a residential rental property is relatively close to how long the average heating system lasts. A gas furnace should last 15 to 25 years, while a heat exchanger is good for 15 to 30 years and an oil furnace is good for 20 to 30 years. Boilers last longer -- 30 to 50 years for cast iron and 30 to 40 years for steel.
If your furnace doesn't last as long as the IRS says, or if you choose to replace it for any other reason, you will have to stop depreciating it. If you sell it for less than your depreciated value, you can realize a capital loss. However, if you write it off and replace it, it will stay with your building's basis and reduce your capital gains and recapture taxes when you sell. You can't treat the retirement of part of a piece of real property by itself as a sale.
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