When you invest in rental property, you are likely seeking to earn income from renting out the property to tenants. Many of the expenses associated with the property, like property taxes, repairs, maintenance, and professional management, are deductible from the income you earn in the same year that you spend the money. Depreciation of the actual cost of obtaining the property is different because the asset has a long useful life, unlike the transitory nature of services that you can deduct on a current basis.
Since real estate has a useful life span (defined by the IRS for residential property as 27.5 years), the period for depreciating the cost of acquiring that asset is 27.5 years. It's essential to keep in mind that the depreciation allowed only includes the improvements, such as buildings, not the land itself, which does not lose its utility with time. This length of service equates to approximately 3.636% of the value each year.
How Does Depreciation Work If I Own a Rental Property?
Suppose that you own a duplex, for which you paid $650,000. Remember that the land is not subject to depreciation, so you need to determine the value of the improvements (the housing structure, including the garage and amenities like a pool or laundry facilities. You can also add closing costs to the sales price to determine the basis--that includes legal costs, recording or escrow fees, property survey costs, septic inspection, and environmental inspection. If the basis is determined to be $500,000, you divide that amount by 27.5 to arrive at the number you can deduct annually for depreciation. The result is $18,181.81.
Note that you adjust the depreciation to accommodate the shortened schedule if you place the property into service part way through the year. Putting the property into service is defined as when it is available for occupancy, not necessarily when it is occupied. For example, if you acquire the duplex in January, spend three months making repairs and renovations, and begin to look for a tenant in April, the property is placed in service in April, even if a paying tenant does not occupy it until June or July. The IRS publishes a schedule showing the lower percentages used when depreciating a property that was placed into service partway through a tax year.
The depreciation method for any rental property placed into service after 1986 is an accounting system called MACRS (Modified Accelerated Cost Recovery System), calculated either by the General Depreciation System (GDS) or the Alternative Depreciation System (ADS). Investors should consult their tax advisor when choosing since electing the ADS may be irrevocable and is less common for most situations.
What Is Depreciation Recapture?
When a taxpayer deducts the allowable depreciation of a real property asset from taxable income, this reduces the amount that the individual pays in taxes (or potentially increases the refund obtained). Either way, it is an offset to income. If the taxpayer later disposes of the asset at a higher price (a taxable gain), the IRS wants to recoup its share of that increase. The method for paying that back to the IRS is called depreciation recapture, and it is assessed at 25%.
Using the duplex property from the above example, if the taxpayer owned it for five years and deducted $18,181.81 each year, the total depreciation claimed would have been $90,909.05. The depreciation recapture amount due is $22,727.26. Also, there will likely be a capital gains tax owed. The investor can defer both the depreciation recapture and the capital gains payment by considering options like a 1031 exchange for the transaction.