Allowable expenses are essential business costs that are not considered part of the company’s taxable profits. When it comes to depreciation as an allowable expense, it refers to depreciation that an investor or business is allowed to deduct from its tax liabilities. If you own rental property, the IRS views depreciation as a rental expense, which may be tax-deductible.
Depreciation write-offs can significantly impact an investor’s tax liability, so you must understand the complex rules about how depreciation can be used as a tax deduction.
Understanding Real Estate Depreciation
Depreciation represents how much of an asset’s value has been used or declines over time. In terms of real estate investment, depreciation is an income tax deduction that allows investors to recover the cost of property or assets over their useful life. You can start taking depreciation deductions from your eligible property as soon as the property is placed in service and when it’s available for rental.
Most U.S. residential rental property is depreciated at a rate of 3.636% each year for 27.5 years. For commercial real estate, it’s 39 years. Only the value of the buildings can be depreciated, not the land.
Is My Property Eligible for Depreciation?
According to IRS Publication 946, depreciable property must follow these requirements:
- It must be property you own, even if it is subject to debt.
- It must be used in your business or income-producing activity.
- It must have a determinable useful life.
- It must be expected to last more than one year.
In addition to the above requirements, the property cannot be depreciated if you put it in service and dispose of it or no longer use it for business use within the same year. The land the property sits on can also not be depreciated. Land has no determinable useful life. You also cannot depreciate the costs of clearing, planting, and landscaping.
You can deduct for depreciation up until the entire basis in your property has been deducted or until the property has been sold, exchanged, or converted to personal use.
How Can Depreciation Affect Taxes?
Depreciation can help investors by spreading out the cost basis of a property over its useful life, allowing you to claim deductions for every one of those years, provided that it remains eligible.
Keep in mind that if or when you decide to sell the property, depreciation reductions often result in higher gains, which are taxable. This is known as depreciation recapture, which is the gain realized by the sale of a depreciable capital asset, which must be reported as ordinary income.
Depreciation recapture is also equal to 25% of the aggregate depreciation allowance taken over the investment holding period. Fortunately, you can also defer depreciation recapture and capital gains tax by conducting a 1031 exchange.
When filing taxes, depreciation of rental property is reported on Schedule E on Form 1040. However, Form 4562 may be used if you claim depreciation on a rental property in the year that you put it into service.