How Rental Property Depreciation Works

For property owners renting properties, real estate depreciation can be a valuable tool. This allows you to subtract the costs of purchasing and improving a property during its useful lifetime. It also lowers your taxable income.

Writing Off Taxes

Renting property is a smart investment. A rental property can be a stable source of income and help you build equity as the property (ideally) appreciates over time. There are many tax benefits. There are many tax benefits. You can often deduct rental expenses from rental income, which will lower your overall tax liability.

The majority of rental property expenses, such as mortgage insurance, property taxes, and repair and maintenance costs, are deductible within the year that you spend the money.

Real Estate Depreciation

Another important tax deduction, the allowance for depreciation, works slightly differently. The process of depreciation allows you to subtract the cost of renting out a property. However, depreciation does not allow you to take one large deduction for each year that you purchase (or improve) the property. Instead, it distributes the deduction over the property's useful life.

The Internal Revenue Service has very specific rules about depreciation. If you have rental property, it is important to know how this process works.

Which Property Is Depreciable?

The IRS says that you can depreciate a rental home if it meets these conditions:

• The property belongs to you (even if it is subject to a loan).

• The property can be used in your business or as an income-producing venture.

• Property has a predictable useful life. This means that it can wear out, decay, get used up, become obsolete, lose its value due to natural causes, and so on.

• It is expected that the property will last more than one year.

Even if your property meets the above requirements, you cannot depreciate it if it is in service and then disposed of (or it is no longer used for business purposes) within the same year.

The land is not considered to be depreciable because it never gets "used up." 2 In general, it is not possible to depreciate costs associated with clearing, planting, and landscaping. This is because these activities are part of the land's cost and not the buildings.

When Does Depreciation Begin?

Depreciation deductions can be taken as soon as the property is placed in service or when it becomes available for rental.

Let's say you buy a rental house on May 15. After several months of work on the property, it is ready for rental on July 15. You then advertise the property online and in local newspapers. The tenant is found, and the lease starts on September 1. You find a tenant, and the lease begins on September 1.

You can continue depreciating the property until you meet the following conditions:

• You have taken out your entire cost or any basis from the property.

• Even if the cost of the property has not been fully recovered, you can retire it from service. You can retire property from service if you are unable to use it as an income-producing asset, sell it or trade it, convert it into personal use, or destroy it.

Property that is temporarily "idle" can still be claimed a deduction from depreciation. You can depreciate the property even if repairs are made after a tenant has moved out.

How To Calculate The Depreciation

The amount of depreciation that you are allowed to deduct each year depends on three factors: the basis of the property, the recovery period, and the method used.

The Modified Accelerated Cost Recovery System (MACRS) is used to depreciate residential rental properties that were placed into service after 1986. This accounting method spreads out costs and depreciation deductions over 27.5 years. This is how long the IRS considers a rental property to have been in service.

It is always a good idea to consult a qualified tax advisor for depreciation calculations.

Here Are The Basics:

Define The Basis Of Your Property:

The basis includes closing fees and settlement costs. These include legal fees, recording fees, surveys, and transfer tax. Title insurance and any amount that the seller owes you (such as back taxes). Your basis cannot include certain settlement fees or closing costs. Some settlement fees and closing costs cannot be included on your basis.

You Can Separate The Costs Of Land And Buildings:

To depreciate each correctly, you need to determine their value. You can either use the fair value for each property at the time of purchase or base your value on the assessed real-estate tax values. Imagine that you purchased a house for $110,000. According to the most recent real property tax assessment, the property is valued at $90,000. $81,000 goes towards the house and $9,000 for the land. Therefore, you can allocate 90% (or $90,000.) of the house's purchase price and 10% (or $90,000.) to the land.

Calculate Your Properties Basis:

Once you have the property's basis (house and land) and the house's value, you can calculate your house's basis. The above example would show that your basis in the house, which is the amount that can be depreciated, would be $99,000 (90% of $110,000). Your basis in the land is $11,000 (10% of $110,000).

Calculate The Adjusted Basis If Needed:

There may be occasions when your property is available for rent. Several factors can increase the basis. These include money spent on repairs and improvements to the property. You may also see a decrease in basis due to insurance payments, such as those for damage or theft, loss of casualty, or money that you received to bring utility services to the property.

Which System Should You Use?

Next, you will need to determine which of the two MACRS is applicable: the Standard Depreciation System or the Alternate Depreciation System. GDS applies to all properties that are in service.

ADS Must Be Completed When The Property Is Being Sold:

• Qualified businesses use less than 50% of their time.

• Is it exempt from tax?

• Are tax-exempt bonds used to finance the project?

• It is used primarily in agriculture.

GDS is generally preferred unless there are exceptional circumstances that require ADS. It is recommended that you consult with a qualified tax accountant to help you decide the best way to depreciate rental property.

The property's recovery period can be determined once you have identified which MACRS system is applicable. GDS has a 27.5 year recovery period for residential rental properties. ADS uses ADS for ADS property. Therefore, the property's recovery period would be 30 years if it was placed in service after December 31, 2017, and 40 years if it was placed in service before that date.

Next, calculate the annual depreciation limit. We'll be focusing on this calculation as most residential rental properties use GDS.

You would depreciate 3.636% for every year that a property has been in service. This applies as long as the property is being depreciated each year. You would lose a lower percentage if the property was only in use for a year. For example, if you purchased a house in May but started renting it out in July, it would depreciate less that year, depending on when it was placed in service. The IRS Residential Rental Property GDS Table.

What Is The Tax Reduction Effect Of Depreciation?

When you file your annual tax return, you should report any rental property's rental income and expenses. Your 1040 form will show the net gain or loss. In addition, you'll need to include depreciation on Schedule E. This will reduce your tax liability for the entire year.

For example, if you depreciate $3599.64 and are in the 22% tax bracket, you will save $791.92 ($3,599.64x0.22) in taxes for that year.

The Summary

If you are looking to invest in rental properties, depreciation may be an asset. It allows you to spread the cost of the property over many years, which can reduce your tax bill. You'll have to pay tax if you sell the property for more than its depreciated price.

It is a good idea to consult a qualified tax accountant before you start, operate, or sell your rental property business. Rental property tax laws can be complicated and are subject to change frequently. This will ensure that you receive the best tax treatment possible and prevent any unexpected tax surprises.