It is surprising that the guidance for such a common situation is not more clear.
I have a client who took a rental out of service that likely will not be treated as a trade or business and then subsequently sold it. As Chay and Brian Coddington have pointed out, there is authority for continuing to depreciate property used in a trade or business and Brian added the following observation above:
Coddington wrote:That's one of those weird things. Section 167 doesn't discriminate and the case law makes very clear that an asset used in a trade or business keeps depreciating until disposed of or converted to personal use. Why the same rule doesn't apply to rentals held solely for the production of income I do not know.
It looks to me like the difference between a trade or business deduction for depreciation and a deduction for depreciation or other expenses related to rental property that is not a trade or business is that the former is allowed as a deduction by IRC 62(a)(1), but the latter must pass through IRC 62(a)(4).
IRC Section 62(a)(4) allows the following:
The deductions allowed by part VI (Sec. 161 and following), by section 212 (relating to expenses for production of income), and by section 611 (relating to depletion) which are attributable to property held for the production of rents or royalties.
Although Section 167 does not discriminate between property held in a trade or business or held for the production of income, Section 62(a)(4) above attaches the additional condition that the deduction must be "attributable to property held of the production of rents or royalties" in order for the Section 212 amount to be deductible against AGI.
One could argue that property that was at any time in the past "held for the production of rents or royalties" would fall under a literal reading of this section, and therefore the deduction of costs after the property is taken of the rental market and listed for sale should be allowed, but the legislative history construes the meaning of this section narrowly:
The deductions described in clause (1) above are limited to those which fall within the category of expenses directly incurred in the carrying on of a trade or business. The connection contemplated by the statute is a direct one rather than a remote one. for example, property taxes paid or incurred on real property used in the trade or business will be deductible, whereas state income taxes, incurred on business profits, would clearly not be deductible for the purpose of computing adjusted gross income. Similarly, with respect to the deductions described in clause (4), the term “attributable” shall be taken in its restricted sense; only such deductions as are, in the accounting sense, deemed to be expenses directly incurred in the rental of property or in the production of royalties. *** (S. REPT. 885, 1944 C.B. AT 877-878)
This language was relied upon by the court in applying this section in the Strange case which dealt with whether an income tax levied upon royalty income was deductible under IRC 62(a)(4), as follows:
The language and structure of section 62(a) reveal Congress's intent that state income taxes levied on net royalty income (gross royalty minus production taxes, overhead, operating expenses, and depletion) are not deductible above-the-line. Such income taxes are not expenses incurred in the production of the royalty. See Accountants' Cost Handbook, 1.9 (James Bulloch et al. eds., 3d ed. 1983) (defining expenses as “expired costs ...used to produce revenue”). Above-the-line deductions must be attributable to “property held for the production of ...royalties” — not attributable to the royalties derived therefrom. I.R.C. section 62(a)(4) (emphasis added). The language and sentence structure plainly divide the “property” from the derived “royalties.”
So if the costs deductible under 62(a)(4) for a rental that is
not a trade or business must be "expired costs ...used to produce revenue," and must be "expenses directly incurred in the rental of property or in the production of royalties," then it seems that a more stringent standard may exist for these costs than for trade or business costs and that the IRS position in Publication 527 quoted above may have some weight.
This is not the conclusion I wanted to come to, so hopefully someone will be able to point out a flaw in this analysis.