People that know how to invest in real estate understand the exceptional potential value of owning rental properties. They generate monthly cash flow through rental income and offer increasing value through appreciation. In addition, there are several beneficial rental property tax deductions.
Rental property owners can enjoy tax benefits by deducting most of their expenses, including insurance, property management fees, repairs, maintenance, office expenses, and travel. They can also take a depreciation deduction. Understanding exactly what depreciation is and how it works will set you up for success when it comes to getting the most out of your rental property.
What Is Depreciation?
Depreciation is an accounting term used to describe the declining value of an asset over time. In other words, depreciation refers to how much of an asset's value has been used. When it comes to assets owned by a business, depreciation allows them to pay for the assets over time instead of incurring the entire cost at the time of purchase. They can write off the asset's value over a more extended period during its useful life.
When a business purchases an asset, it records it as a debit on its balance sheet. A balance sheet is a financial statement that covers all of the company’s debt, assets, liabilities, equity capital, and other financial indicators.
At the end of the company’s accounting period, an accountant uses the balance sheet to add the depreciation for all assets that are not yet fully depreciated. This means the company can use depreciation to enhance its balance sheet and tax deductions.
When taxes are due, the company can take a deduction for the asset's purchase price, which reduces their taxable income. The depreciation expense is recorded as a debit on the balance sheet in relation to their income statement. The accumulated depreciation is reported on the balance sheet as a credit.
What Is Rental Property Depreciation?
Rental property owners can use depreciation to help their balance sheets and tax deductions. To do this, they must show the Internal Revenue Service (IRS) that their real estate has a determinable useful life.
As you might imagine, this can vary greatly depending on the real estate in question. A rental property built a month ago might have a very long useful life. A rental property built in 1920 may not. However, a rental property constructed cheaply may only last 15 years, and a 100-year-old building that was constructed well may continue to be in great shape for renting for years to come.
The discrepancies between different rental properties are vast, so the IRS has guidelines to help determine real estate depreciation. If you are an investor that purchases residential rental real estate, the IRS says you can use the figure of 27.5 years when determining the useful life of the property. That means you can divide your cost basis (more on this later) in the rental by 27.5 to determine the expense of annual depreciation. For commercial properties, the depreciation period, according to the IRS, is 39 years.
It’s essential to keep in mind that only the value of the building, not the land it is built on, can be depreciated. Land is considered to have an infinite useful lifespan.
Now that you understand the basics of how rental property depreciation works, let’s dive into some of the criteria.
Criteria For Rental Property Depreciation
Some conditions need to be met to claim depreciation on your rental property when tax time comes around. First of all, you must own the property. That makes sense, right? In addition, the rental property must provide income for you. This is true of most rental properties. After all, if you don’t have a rental property that is producing income, you have more significant problems than tax deductions to worry about.
As previously mentioned, you need to be able to determine the useful life of the property. Luckily, this is somewhat standardized in real estate, with the aforementioned 27.5 years for a residential rental property and 39 years for a commercial property. Lastly, the useful life of the property must be more than one year. If you own an asset that will wear out in under a year, it cannot be depreciated on your tax return.
How To Calculate Rental Property Depreciation
Before you do that, let’s make sure you understand how the calculation works.
The process has three main steps:
The initial value you use to determine any future depreciation is considered your cost basis. The value is dependent on several factors, including the monetary value of your property and certain closing costs.
For an investment property, the monetary value of your property is the purchase price. If you bought the property as a primary residence and converted it to a residential rental property, you need to get an appraisal to determine the value.
There are also some (but not all) closing costs that can be added to the value to determine your cost basis. These include:
Land Vs. Buildings
As mentioned, buildings can be depreciated but not land. That means you need to find the value for the land and the building separately to accurately determine your cost basis for depreciation.
Start with fair market value for the land and building when you purchased the rental property. Or, you can use the amount assessed in the tax records.
Example: You bought a residential rental property for $250,000. According to the most recent tax assessment, the property's value is $225,000 (the building is $200,000 and the land is $25,000).
This means you can designate 89 percent ($200,000 divided by $225,000) of what you paid to the structure and 11 percent ($25,000 divided by $225,000) to land. This means you can calculate your cost basis for the building by taking 89 percent of the price you paid for the property ($250,000), which would be $222,500.
Adjusted Cost Basis
At this point, calculations may not be over. There are certain occurrences where you will need to increase or decrease your cost basis. If you made renovations or additions to the property before you started renting it, those could be added. You can also add any money you spent to service the property or repair damage. Certain legal fees can also be added.
If you received insurance payments for damage, theft, or loss, those need to be taken away to decrease your cost basis. In addition, if you received money to grant an easement on the property, this needs to be taken off your cost basis as well. An easement is when the owner of a property allows someone else to use all or part of it without giving up ownership. Allowing a neighbor to use a driveway on your property to get to their house would be an example of an easement.
Rental Property Depreciation Example
Using the previous example of a residential rental property with a cost basis of $222,500 and the depreciation recovery period outlined by the IRD of 27.5 years, let’s calculate depreciation.
For each entire year the rental property is in service, you calculate an equal amount of depreciation. This comes out to 3.63%, assuming you continue to depreciate the property each year over its 27.5 useful life span. If you bought the property mid-year, you would need to prorate the percentage. Here is a month-by-month breakdown.
Let’s use the previous example of a property with a cost basis of $222,500. Imagine you bought the property, and it was put into service as a rental property in May. For the first year, you would depreciate at a rate of 2.273%, or $5,057.43 (2.273 percent of $222,500). For every full year, the rental property is in service after that, you would depreciate at a rate of 3.636%, or $8,090.10 (3.636 percent of $222,500).
Rental Property Depreciation And Taxes
So, how do the tax benefits of rental property depreciation work exactly? When they file their taxes, real estate investors report their rental income and expenses on a Schedule E form. They report their net gain or loss on a 1040 form. Depreciation is one of the expenses to include on the Schedule E form. This reduces a real estate investor’s overall tax liability when they file taxes each year. Continuing with the example above, if you depreciate $8,090.10 and you are in the 22 percent tax bracket, you would save $1,779.822 ($8,090.10 x 0.22).
Rental property depreciation is a useful financial tool for a rental property owner to use during tax time. It allows them to spread the cost of purchasing real estate over many decades and reduces their tax bill each year.
Investment property tax benefits and laws are complicated and constantly changing. Work with a qualified tax accountant to make sure you are filing your taxes in a way that will optimize your financial returns each year.