Depreciation is the process of reducing your tax liability thanks to the IRS’s underlying belief that wear and tear reduce the value of and potential income generated by a rental property.
What is Depreciation?
Depreciation is when you subtract the cost of buying and improving rental property from the taxes you pay. Instead of making the deduction in the year you purchase or improve your property, depreciation divvies out the deduction across the useful life of the property (the useful life of an asset is the estimated amount of time it can provide cost-effective income). It’s a non-cash deduction. Instead, depreciation lowers your taxable income.
How Does Rental Property Depreciation Work?
The starting assumption of real estate depreciation is that wear and tear make your property decline over time. This, however, isn’t typically the case. A properly maintained property whose parts are appropriately replaced will continue to generate income, and may even appreciate in value.
So, you may have a cash flow from your property while still showing a tax loss. This is just a quirk of rental property investment! Few other types of investment have comparable depreciation deductions.
What is Depreciable?
Property that’s rented is depreciable, as are improvements to the property. Land, however, is not, so you’ll have to separate the cost of the land from the cost of the property. Maintenance is also not depreciable.
For a property to be depreciated it has to meet all of the following criteria:
- You own the property. It doesn’t matter if the property is subject to debt; the important thing is that you are considered the property’s owner.
- You use the property to generate income as part of a business.
- The useful life of the property is determinable. This means that the property is something that experiences wear and tear in various forms and ultimately goes down in value.
- The property is expected to be around for more than one year.
The property can’t be depreciated, though, if you got rid of it the same year that you got it, or if you stopped using it the same year you got it.
Clearing, planting, and landscaping are all classified as part of the cost of the land, so that cannot be depreciated.
Some improvements that count toward depreciation include:
- new additions to the property
- air conditioning, heating, etc
- roof replacement
- wall-to-wall carpeting
- wheelchair ramps
- other accessibility upgrades
Regular repair and maintenance, however, do not count toward depreciation. Maintenance is simply deducted in the year you spend the money. Fixing a crack in your driveway is maintenance; replacing your entire driveway is depreciation.
When Does the Depreciation Period Begin and End?
Depreciation starts as soon as the property is either rented or ready and open to being used as a rental. Depreciation continues until you’ve deducted the entire value of the property, or until you stop renting the property. The latter stipulation holds even if you’re not fully made back the cost of the property. This may happen because the property is no longer rented, you sell or exchange it, start using it yourself, abandon it, or if it’s destroyed.
The one exception is if the property is “idle” or not in use for some time. If you’re making repairs to the property between tenants, you can still depreciate the space during that time.
How Should I Determine the Appropriate Depreciation Method?
There are three considerations when calculating your year’s depreciation: your basis in the property, the recovery period, and the depreciation method used. If your property was put to use after 1986, depreciation is assessed using the Modified Accelerated Cost Recovery System (MACRS), which is an accounting formula that spreads costs over a period of 27.5 years. That’s the number of years the IRS considers to be the “useful life” for a rental property.
Determine the basis of the property
The basis is the amount you paid for the property, whether it be in the form of cash, a mortgage, or some other means. Your closing costs and all other fees are also included in the basis, although some aspects of the closing costs and fees are not included.
Some examples of excluded figures are:
- fire insurance premiums
- rent charged before the closing
- costs of getting refinancing
- mortgage insurance premiums
- credit cards
- the cost of an appraisal
Separate the cost of land and buildings
As you may remember, land does not depreciate. So, you must determine the cost of the land and the cost of the home and subtract one from the other. You can use the fair market value of each at the time of purchase, or you can use the assessed real estate values.
Let’s say you bought the property for $110,000, and the most recent real estate tax assessment says the property costs $90,000, with $81,000 being for the house and $9,000 being for the land. With those figures in mind, you can separate 90% ($81,000 ÷ $90,000) of the purchase price for the house and the rest, 10% ($9,000 ÷ $90,000), for the land.
Determine the adjusted basis (if necessary)
You may need to alter your basis between the purchase of the property and the moment your property is actually rentable. The basis might go up, for example, if you spend money to restore damaged property, spend money on legal fees or have to pay to get utility services to the property. Decreases to the basis may be caused by insurance payments you received due to damage or theft.
What are Common Depreciation Methods?
In most cases, the General Depreciation System (GDS) will be used to calculate your depreciation. This is something you’re best off having a tax professional do for you. You’ll use the Alternative Depreciation System (ADS) only if you meet the following criteria:
- Your property has a qualified business use equal to or less than 50% of the time.
- Your property has tax-exempt use.
- Your property is financed by tax-exempt bonds.
- Your property is primarily used for farming.
How Do I Calculate the Depreciation?
The General Depreciation System (GDS) applies the declining-balance method rate on a non-depreciated balance. If an asset valued at $1,000 is depreciated 25% on a yearly basis, then the deduction os $250.00 in year one $187.50 in year two, and so on.
You’ll go the GDS route until there’s a reason to use ADS. The recovery period for a property is 27.5 for GDS. For ADS, the recovery period is 30 years for property serviced after Dec 31, 2017, and 40 years for a property placed into service before then. Using the GDS system, you’ll depreciate the property by 3.636% each year. If you rented your property for only part of the year, then you’d depreciate the property for less. You’d use the Residential Rental Property GDS table to make that determination:
- January: 3.485%
- February: 3.182%
- March: 2.879%
- April: 2.576%
- May: 2.273%
- June: 1.970%
- July: 1.667%
- August: 1.364%
- September: 1.061%
- October: 0.758%
- November: 0.455%
- December: 0.152%
So, if you have a property that cost you $99,000 and it was rented out on July 15th, you’d depreciate 1.667%, or $1,650 ($99,000 x 1.667%) the first year, and then the rest at a rate of 3.636%, or $3,599.64 (so long as the property is rented the entire year). This number is basically taking the cost of the property and dividing it by 27.5. The only difference in this example was that the property was used for only part of the year the first year.
How Much Does Depreciation Reduce Tax Liability?
Usually, you report your rental income and rental expenses on the appropriate line of Schedule E, and your net gain or loss goes on your 1040 form. Depreciation is included on Schedule E, so it makes your tax liability less every year. If you depreciate $3,599.64 and you’re in the 22% tax bracket, then you’ll pay $3,599.64 x 0.22 = $791.92 less in taxes that year.
How Do I Report Depreciation of Rental Property?
Depreciation is reported when you fill out your taxes. While you can do it all yourself, it’s best to have a tax professional do it for you. After all, you are making money off your rental property, so why even risk compromising your profit?
1. Use a Schedule E to Record Income and Expenses
Since your rental property is depreciable but its land is not, you’ll have to separate the value of the two to calculate depreciation. You’ll use Schedule E to documental the income and expenses of your rental property. The net gain or loss is recorded on your 1040 form, which also where your record your depreciation.
2. Figure Out Your Net Gain or Net Loss
Some examples of improvements that count toward depreciation include a new roof, replacing the bathroom, and replacing the kitchen. The way you depreciate these is by dividing the cost of the improvement by the useful life of the improvement If you spent $15,000 on a new roof with a 15-year useful life, then you divide $15,000 by 15 to get $1,000. That means you can write off $1,000 per year during the driveway’s 15-year long useful life.
3. Depreciate the Purchase of the Property
After you subtract the cost of the land from the cost of the property, divide that amount by 27.5 years. So, if your property is $175,000 after the cost of land has been subtracted, your depreciation is $175,000 ÷ 27.5 = $6,363.64 per year. Your tax liability goes down $6,363.64 while your income remains untouched.
Do I Have to Take Real Estate Depreciation?
One of the risks of filing your own taxes is overlooking depreciation. A lot of first-time real estate property investors simply don’t know that depreciation exists. There’s no penalty for not taking advantage of depreciation, other than the penalty of not taking depreciation! Luckily, you can take your depreciation benefit after the fact. Just file an amended tax return using Form 1040X, in addition to any other schedules or forms you’re changing.
How Does Deprecation Affect Selling?
There is one sizeable drawback to depreciation. If you take depreciation deductions every year, your cost basis in your property goes down for capital gains purposes. So, if your cost basis is $200,000 and you’ve made use of $25,000 worth of depreciation, then the IRS uses the number $175,000 to calculate capital gains. That means that if you sell your property for $300,000 (after expenses), the IRS uses $125,000 to calculate capital gains rather than $100,000.
What you can do, however, is a 1031 exchange. This will get you out of paying capital gains taxes! Simply put, a 1031 exchange is when you use all of the money made on the sale to purchase a property of equal or greater value. A 1031 exchange is also a great way to change up your real estate investment, whether it be for the purpose of diversification or to no longer have to deal with a high maintenance property.
Depreciation is a way to save money when investing in a rental property. It makes it easier to own rental property because the less money you pay on taxes the more you have to reinvest into your business. And since managing a rental property can be quite demanding financially, you’ll need all the help you can get! It’ll be worth it, though, because real estate provides a steady income source, appreciates in value, and has a low correlation with other commodities and the stock market, which means it can help you ride out hard times.