Owning and maintaining a rental property can be expensive — not to mention a lot of work. Luckily, some of the expenses are deductible and claiming depreciation helps defray the cost of property ownership. Depreciation is a deduction that allows the investor to recoup the cost of assets (in this case, the rental property) used as a source of income.
Whether or not you choose to take depreciation doesn't matter to the IRS. When you sell a property, the IRS levies a fee on the depreciation you should have claimed.
According to the IRS, “depreciation is the recovery of the cost of the property over time. You deduct a part of the cost annually until you fully recover its cost." The IRS considers that real estate and other physical assets wear down over time.
You can’t fully recover the entire cost of the rental property in a single year, which is why you spread the deduction over the useful life of the asset to match annual wear and tear. You can depreciate a rental property if it meets these requirements:
Land cannot be depreciated because it cannot wear down over time. Land costs include clearing, grading, planting, and landscaping.
According to the IRS, the expected useful life of a rental property is 27.5 years. Therefore, each year, you can deduct 3.636% (100% / 27.5 years) of the rental property's cost basis from your annual income. This deduction reduces the amount of income subject to taxation.
This IRS allows you to depreciate some repairs and improvements made to the property in fewer than 27.5 years. For example, appliances may be depreciated over five years, office furniture and equipment over seven years, and roads and fences over 15 years.
After 27.5 years, the entire cost basis has been deducted, and depreciation ends. Depreciation can also stop after the property is sold or the rental property stops producing income.
Rental property depreciation can be a considerable tax advantage for investors. For example, suppose your rental property produces $8,000 in annual income after all expenses. A $3,000 depreciation expense reduces the property's taxable income to $5,000. Some investors may be tempted to skip claiming depreciation to avoid the risk of depreciation recapture tax, but this generally won’t succeed.
The IRS assumes that you have taken a depreciation deduction. You will owe 25 percent of what you could have deducted as a “depreciation recapture” when you sell the property. That amount is due whether you take a deduction or not.
If you haven't claimed depreciation on your tax return, you can amend your recent tax return to claim your depreciation benefit. To do this, file an amended return by filling out Form 1040X and other forms you're modifying. For depreciation deductions, use Schedule E.
Gains are the goal, and taxes are a part of the process. However, savvy investors look for ways to manage and favorably schedule their tax payments. For example, holding property in a tax-advantaged trust can be feasible, but the tactic may sometimes limit control. Having some assets in a retirement account may allow the investor to defer taxes until they are in a lower bracket. Also, an investor may be able to delay capital gains taxes by using a 1031 exchange to execute the transaction when selling a property and reinvesting in another. Finally, there is still potential for deferral and tax reduction by directing capital to a QOF (Qualified Opportunity Fund) project. Make sure to seek professional advice on these options.