Rental property depreciation can be one of the most powerful tools for landlords and property owners for minimizing tax liabilities and managing the financing of an acquired rental property. Depreciation allows property owners to deduct the cost of the property over time. This can significantly reduce taxable income.
But, what is rental property depreciation?
At its core, rental property depreciation is the process of accounting for the wear and tear, decay, or obsolescence of a rental property. By spreading the cost of the property over its useful life, owners can take advantage of annual tax deductions.
Understanding depreciation is crucial for both new and seasoned investors. For newcomers, depreciation can be a big deal as it can mean the difference between a profitable investment and a financial misstep. Meanwhile, for all investors, rental property depreciation is a useful strategy to optimize tax savings and maximize investment returns.
Knowing how to leverage this tool can enhance the financial stability and growth of your rental property portfolio.
What Is Rental Property Depreciation?
Rental property depreciation is a tax deduction that allows property owners to recover the cost of their property over time. This deduction accounts for the natural wear and tear that occurs as the property ages.
To claim depreciation, the IRS lets you take a portion of the property’s value as a deduction each year. The rates can be different, so it’s best to check with an accountant or the IRS. Most of the time, the depreciation rate stands at 3.636% for 27 years, according to the IRS.
To understand depreciation, think of it as a way to spread out the cost of your property over many years. Instead of taking one large deduction in the year you bought the property, you take smaller deductions each year. This method helps reduce your taxable income, leading to lower taxes.
Depreciation is vital for several reasons.
First, it reduces the amount of income tax you owe each year. Second, it affects the value of your property over time, helping you manage your investment more effectively. Whether you are new to property investment or have years of experience, understanding depreciation can help you make smarter financial decisions and maximize your returns.
How Rental Property Depreciation Works
Rental property depreciation involves several key steps and concepts. By understanding how it works, you can make the most of this valuable tax benefit.
When we talk about how rental property depreciation works, we are talking about the different calculations that go into the depreciation of a rental property.
Here are some of the aspects surrounding depreciation calculations.
Depreciable Basis
The depreciable basis of a property is the amount you can depreciate over time.
It starts with the property’s purchase price, but you need to subtract the value of the land because land does not depreciate. Only the building and any improvements on the property can be depreciated.
In a nutshell, the depreciable basis is the property cost minus the land value.
For example, if you buy a property for $300,000 and the land is valued at $50,000, the depreciable basis is $250,000.
Depreciation Methods
The most commonly used method for calculating depreciation is the Modified Accelerated Cost Recovery System (MACRS).
This system allows you to take larger deductions in the earlier years of the property’s life and smaller ones later on. This matches the actual decline in the property’s value over time.
Depreciation Periods
The IRS sets specific periods over which you can depreciate a property.
For residential rental properties, the standard depreciation period is 27.5 years, but for commercial properties, it is 39 years.
These periods reflect the expected useful life of the property.
How To Calculate Rental Property Depreciation
Calculating rental property depreciation is a key step in the depreciation filing process and involves several essential steps to determine the annual deduction you can claim on your taxes.
Step 1: Determine Your Rental Property’s Basis
The basis of a property is critical for depreciation calculations, and it includes the initial cost of acquiring the property, which comprises the following:
- Purchase Price: This is the amount you paid to acquire the property.
- Closing Costs: These costs include fees associated with closing the real estate transaction. These costs can be anything from title insurance to legal fees and recording fees.
- Improvement Costs: You can add costs for improving your rental property into your depreciable basis calculation. The expenses for improving the property are vital for adding to its value or extending its useful life, and these costs can be renovations or repairs.
For example, imagine that you purchased a residential rental property for $300,000.
When you bought the property, closing costs amounted to $8,000, and you spent an additional $15,000 on renovations immediately after purchase.
As a result, the total basis for depreciation calculation would be $323,000 ($300,000 + $8,000 + $15,000).
Step 2: Separate Land Value
Your residential property can lose its value and usefulness over time.
However, in the eyes of the IRS, what doesn’t depreciate is land. For this reason, you’ll want to separate your property’s land value from your depreciation calculations.
To determine your land’s value separate from the property’s total value, tax assessments and a professional appraisal are essential.
- Tax Assessments: For official assessments, these need to be conducted by local tax authorities.
- Professional Appraisal: Hiring a qualified appraiser enables you to accurately evaluate your rental property’s land value.
Let’s illustrate how to delineate your rental property’s value from how much the land costs.
Imagine that your property basis was $323,000. After determining this figure, you hired a professional appraiser who found your land’s value to be $50,000.
Right away, your land value is $50,000.
Step 3: Calculate the Depreciable Basis
The depreciable basis is the amount of the property’s cost that can be depreciated over its useful life and is calculated by subtracting the land value from the total basis.
Hence, if your land’s value is $50,000, you must then take this appraised figure and deduct it from your property basis.
This works out to about $273,000 ($323,000 – $50,000 = $273,000).
Step 4: Choose the Depreciation Method
After you’ve determined your depreciable basis, you must now select the appropriate depreciation method for your property.
Selecting the appropriate depreciation method is crucial and depends on IRS guidelines and the property type (residential or commercial).
There are two primary methods:
- Straight-Line Method: This allocates an equal amount of depreciation expense each year.
- MACRS (Modified Accelerated Cost Recovery System): This depreciation method is a way to determine the accelerated depreciation over a predetermined recovery period.
For a residential rental property under MACRS, the depreciation period is 27.5 years.
By contrast, the straight-line method spreads depreciation evenly over this period.
Step 5: Consider Depreciation Periods
When we talk about depreciation periods, we mean the length of time it takes for your rental property to incrementally lose its value.
These periods are different depending on property type.
According to the IRS guidelines, residential rental properties have a depreciation period of 27.5 years while commercial properties can take as long as 39 years to depreciate.
The Benefits of Rental Property Depreciation
Rental property depreciation isn’t just a way to calculate how your property loses its value over time. Leveraged correctly, it can confer numerous benefits, ranging from tax deductions to improved portfolio management.
Here’s how you can benefit from rental property depreciation in detail.
Tax Advantages
Depreciation allows you to deduct the cost of your rental property over its useful life, providing substantial tax advantages.
By spreading out the deduction over several years, you can lower your taxable income annually and reduce the amount of taxes you owe to the IRS.
Improved Cash Flow and ROI
This tax benefit not only improves your cash flow by reducing immediate tax liabilities but also enhances your property’s overall return on investment.
It provides a steady stream of deductions that can offset rental income and other taxable gains. As a result, leveraging your rental property’s depreciation may increase your after-tax profits.
Strategic Portfolio Management
You can also benefit from rental property depreciation.
Rental property depreciation helps optimize cash flow and improves liquidity by deferring tax payments to future years.
This flexibility in tax planning allows you to reinvest savings into property improvements, expansions, or new investments, further growing your real estate portfolio.
Long-Term Financial Planning
If you’re playing the long game in investment, then rental property depreciation can go a long way in helping you achieve sustainable financial gains.
With the savings you gain from tax deductions and increased ROI, you’ll be able to acquire and preserve more capital for other investment opportunities.
Common Mistakes and How To Avoid Them
Rental property depreciation can be tricky to take advantage of. For this reason, many landlords and investors commonly commit mistakes, failing to reap the tax-deducting and ROI-enhancing benefits of depreciation.
Here are some of the most common mistakes made by investors and landlords, as well as actionable tips on avoiding them.
Mistake 1: Incorrectly Allocating Basis
One of the most significant mistakes is incorrectly allocating the property’s basis between the building and the land.
Land does not depreciate, so it’s essential to accurately determine and separate its value from the total property cost. Incorrect allocation can lead to overestimating depreciation deductions and potential IRS scrutiny.
To avoid committing this mistake, use professional appraisals or reliable tax assessments to determine the land’s value accurately.
You’ll also have to maintain detailed records of property acquisition costs. Among these records are closing expenses and improvements. These records and documents can help support your depreciation calculations.
Mistake 2: Misunderstanding Depreciation Methods
Choosing the wrong depreciation method or misunderstanding its application can result in inaccurate depreciation deductions.
The IRS provides specific guidelines for residential and commercial properties. Different recovery periods and depreciation methods such as MACRS (Modified Accelerated Cost Recovery System) are among these guidelines.
The way to avoid misunderstandings in your depreciation methods is to educate yourself on IRS depreciation guidelines applicable to your property type.
If doing this isn’t tenable, you can consult with tax professionals to select the appropriate depreciation method and ensure compliance with IRS regulations.
These proactive approaches help maximize tax benefits and minimize the risk of penalties.
Mistake 3: Failing To Claim Depreciation
Some property owners overlook or delay claiming depreciation deductions. There are many reasons behind this, but in most cases, it’s either due to a lack of awareness or too much complexity in calculation.
Indeed, the failure to claim depreciation won’t result in any penalties. Nevertheless, it’s an easy way to miss out on significant tax savings and reduce overall return on investment.
There are several ways you can ensure that you reap the benefits of depreciation. An easy way is to implement a systematic approach to track and claim depreciation deductions annually.
Utilize reliable tax software or seek assistance from qualified tax professionals to accurately calculate and report depreciation expenses on your tax returns each year.
Mistake 4: Not Updating Depreciation for Improvements
Improvements made to a rental property should be capitalized and depreciated separately from the original property. Failing to update depreciation schedules for improvements can lead to underestimating tax deductions and missing out on potential tax savings.
If you’re after getting the most out of your tax deductions, keep meticulous records of property improvements and their costs.
For added accuracy, separate and depreciate improvements according to IRS guidelines to maximize tax benefits and accurately reflect the property’s adjusted basis over time.
Mistake 5: Ignoring Recapture Rules
Depreciation recapture rules require property owners to recapture and pay taxes on previously claimed depreciation deductions when the property is sold at a gain.
Ignore these rules, and you may be on the receiving end of unexpected tax liabilities and penalties.
To prevent penalties, learn more about depreciation recapture rules and plan for potential tax consequences when selling a depreciated property.
Alternatively, you can work closely with tax advisors to develop strategies for minimizing recapture taxes and optimizing after-tax proceeds from property sales.
Mistake 6: Overstating Returns or Masking Cashflow issues.
While depreciation doesn't directly affect your cash flow, relying too heavily on depreciation to reduce taxable income can mask underlying cash flow issues. It's important to ensure the property is performing at market regardless of the tax benefits.
How Will Rental Property Depreciation Affect My Taxes?
For the most part, rental property depreciation will have a positive effect on your taxes. More specifically, depreciation can be one of the best ways to lower your tax liabilities.
However, rental property depreciation comes with certain tax implications.
Here’s a look at how depreciation can affect your annual taxes.
Lesser Taxable Income
Depreciation enables you to deduct a portion of your property’s value each year, which directly lowers your taxable income. By spreading the cost of the property over its useful life, you can reduce the amount of income you’d have to pay in taxes.
The result is substantial tax savings annually and improvements in your cash flow and profitability.
For example, if your rental property generates $20,000 in rental income annually and you have $9,927 in depreciation deductions (based on a $273,000 depreciable basis over 27.5 years), your taxable rental income would be reduced to $10,073.
Tax Exemptions From Passive Activity
For the IRS, rental real estate is a passive activity. As a result, passive activity loss rules limit the amount of losses (including depreciation) that you can deduct against other types of income, such as wages or portfolio income.
There are exceptions, however, particularly for active participants or real estate professionals.
For instance, you can still deduct a certain portion from your income taxes if you’re actively involved in managing and operating your rental property.
Depreciation Recapture
When you sell a rental property, the IRS makes you “recapture” the depreciation deductions you’ve taken. This means the amount you’ve depreciated is taxed at a higher rate (up to 25%) instead of the lower capital gains rate.
Let’s illustrate how this works:
If you sell your rental property for $350,000 that you bought for $300,000 and claim $50,000 in depreciation, the $50,000 is taxed at the recapture rate of 25%.
Meanwhile, the remaining gain is taxed at the capital gains rate.
Impact on Property Basis
Depreciation reduces your property’s adjusted basis, which is used to calculate your gain or loss when you sell. A lower basis due to depreciation can mean a higher taxable gain when you sell the property.
Key Takeaways
Rental property depreciation is a powerful liability-reducing tool, offering significant tax advantages and potential for improving cash flow. By understanding how to calculate depreciation and apply it correctly, you can reduce your taxable income.
However, be aware of the tax implications (such as passive activity loss rules and depreciation recapture) when selling your rental property. This is why strategic tax planning with the help of a professional can help you navigate these complexities and make informed decisions.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Sources:
https://www.investopedia.com/articles/investing/060815/how-rental-property-depreciation-works.asp
https://www.irs.gov/publications/p527
https://www.investopedia.com/terms/d/depreciation.asp
