Calculating Annual Income from Property

Emily just received a notice of default on her rental property in Carlsbad. She meticulously tracked mortgage payments, property taxes, and insurance, but completely overlooked the IRS rules regarding calculating “net income” for the estate tax return. Now, her executor is facing a $5,000 penalty for an inaccurate filing, simply because she didn’t understand how to properly allocate expenses and depreciation. These mistakes are shockingly common, and often stem from treating rental property as a personal asset rather than a business within the estate.

As an Estate Planning Attorney and CPA with over 35 years of experience, I’ve seen firsthand how seemingly minor accounting errors can trigger significant tax liabilities for families already dealing with grief and probate. The unique advantage of having a CPA as your estate planning attorney is understanding how these calculations impact the step-up in basis, capital gains taxes, and ultimately, the wealth transfer to your heirs. It’s not just about what you own, but how it’s valued for tax purposes.

What Counts as Income from Rental Property?

The IRS doesn’t simply look at the gross rent collected. Calculating annual income from rental property within an estate requires a detailed analysis of all revenue and deductible expenses. This is especially complex when the owner passed away mid-year. Gross rental income includes not only monthly rent payments but also any advance rent received, lease cancellation fees, and even the value of services (like laundry or maintenance) accepted in lieu of rent.

However, it’s the deductions that truly matter. Many clients underestimate the expenses they can legitimately subtract from gross income. Common deductible expenses include:

Mortgage Interest: The portion of your mortgage payment allocated to interest is fully deductible.
Property Taxes: State and local property taxes are deductible, subject to the $10,000 limit.
Insurance: Premiums paid for homeowner’s insurance, flood insurance, and hazard insurance are deductible.
Repairs: Costs of maintaining the property in good condition are deductible (but improvements are not—those are capital expenditures).
Depreciation: This is where most people stumble. The IRS allows you to deduct a portion of the property’s cost each year to account for wear and tear. This isn’t an actual cash outflow, but a significant tax benefit.
Operating Expenses: This category includes items like property management fees, advertising costs, legal fees, and even mileage driven for property-related business.

How is Depreciation Calculated on a Rental Property?

Depreciation is a non-cash expense, meaning you don’t actually spend money when you take the deduction. The IRS requires you to spread the cost of the property over 27.5 years (for residential rental property). To calculate annual depreciation, you first need to determine the property’s adjusted basis. This is generally the original purchase price plus the cost of any improvements, less any salvage value (which is usually zero).

Let’s say Emily purchased her rental property for $600,000. Her annual depreciation expense would be $600,000 / 27.5 = $21,818.18. While this doesn’t represent actual cash leaving her estate, it does reduce her taxable rental income.

What Happens if the Property is Sold After the Owner’s Death?

The true tax benefit of accurate income calculation comes into play when the property is eventually sold. Properly accounting for depreciation over the years effectively reduces the capital gains tax liability. The “step-up” in basis, as I often explain to clients, is crucial. At the date of death, the property’s cost basis is “stepped up” to its fair market value.

However, the accumulated depreciation is not stepped up. This means the beneficiaries will have to recapture the depreciation taken during the decedent’s lifetime as taxable income when the property is sold. Failing to accurately track depreciation throughout the years can lead to a surprisingly large tax bill upon sale.

What About Expenses Paid After the Date of Death?

This is a common point of confusion. Generally, the estate is responsible for expenses incurred up to the date of death. Expenses paid after that date are typically paid from the estate’s assets and are subject to different rules. It’s critical to maintain clear records of all expenses paid both before and after the decedent’s passing. The executor will need to allocate these costs appropriately on the estate tax return (Form 706) and the final income tax return for the deceased (Form 1040).

For example, if Emily’s property taxes for the entire year were $6,000, and she died on June 30th, the estate would deduct approximately $3,000 (half the year’s taxes) as a rental expense. The remaining $3,000 would be paid from the estate’s funds.

What determines whether a California probate estate closes smoothly or turns into litigation?

California probate is designed to provide court-supervised transfer of property, yet cases often break down when authority is unclear, required steps are missed, or disputes arise over assets, notice, and fiduciary conduct. When the process is misunderstood, families can face avoidable delay, escalating conflict, and increased exposure to creditor issues, hearings, or litigation before the estate can close.

To initiate the case correctly, you must connect the filing steps through petition for probate, confirm the location using jurisdiction and venue issues, and ensure no interested parties are missed by strictly following probate notice requirements rules.

Ultimately, the difference between a routine distribution and a protracted legal battle often comes down to preparation. By anticipating the demands of the Probate Code and addressing potential friction points with beneficiaries and creditors upfront, fiduciaries can navigate the system with greater confidence and lower liability.

Verified Authority on the Petition for Probate

• The Petition (Form DE-111): California Probate Code § 8000 (Grounds for Filing)
  This is the document that starts it all. Under Section 8000, any interested person may file this petition to request the court admit a will to probate and appoint a personal representative. Without this filing, the court has no jurisdiction to act.
• Duty to File the Will: California Probate Code § 8200 (Custodian Duty)
  Holding onto the original Will is a liability. The law requires the custodian to deliver the Will to the Superior Court Clerk within 30 days of the death. Hiding or destroying a Will to prevent probate is a serious legal violation.
• Priority for Appointment: California Probate Code § 8461 (Intestacy Hierarchy)
  When there is no Will, the court does not choose the “best” person; it follows a rigid statutory list. The Surviving Spouse has top priority, followed by children, then grandchildren. Understanding this hierarchy helps predict who will win a contested appointment.
• Probate Bond Requirements: California Probate Code § 8482 (Bond Amount)
  The bond acts as an insurance policy to protect beneficiaries from a dishonest executor. The petition must state the estimated value of the estate so the judge can set the bond amount—typically the value of personal property plus one year’s estimated income.
• Independent Administration (IAEA): California Probate Code § 10400
  The box you check here matters. Requesting “Full Authority” under the IAEA allows the executor to manage the estate efficiently (e.g., selling a house) without constant court hearings. Requesting “Limited Authority” forces the estate into a slower, court-supervised process.
• Proving a Lost Will: California Probate Code § 8223
  If the original Will cannot be found, the law presumes the decedent destroyed it with the intent to revoke it. To overcome this presumption, the petitioner must provide clear and convincing evidence that the Will was merely lost, not revoked.