Depreciation is the process of reducing your tax liability thanks to the IRS’s underlying belief that wear and tear reduces the value of and potential income generated by a rental property. It’s one of the top rental investment property deductions landlords can make!
Thanks to depreciation, a rental property owner enjoys tax savings over their property’s useful life, which is how long the IRS thinks a rental property can generate income. The useful life is 27.5 years for residential property and 39 years for a nonresidential real property like commercial and retail space.
What is Depreciation?
Depreciation is when the taxpayer subtracts 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, the depreciation deduction is divided out across the useful life of the property (the useful life of an asset is the estimated amount of time it can provide cost-effective rental income). It’s a non-cash tax deduction. Instead, annual depreciation lowers your taxable income.
How Does Rental Property Depreciation Work?
For tax purposes, the starting assumption of real estate depreciation is that wear and tear makes the value of your property decline over time. This, however, isn’t always the case. A properly maintained property whose parts are appropriately replaced will continue to generate income and may even appreciate. Even big expenses like replacing your HVAC make your property a better place to live. Nonetheless, depreciation is a capped deduction, meaning that it eventually stops.
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 investment types have comparable depreciation deductions, which makes rental property investment uniquely suited to generating passive income.
What is Depreciable?
Property that’s rented can be a depreciation expense, and so can improvements made to rental real estate. However, the land is not, so you’ll have to separate the cost of the land from the cost of the qualified property. Maintenance also doesn’t count toward annual depreciation, so you can’t write off regular fall maintenance.
Rental real estate to be depreciated it has to meet all of the following criteria:
- You own the residential rental 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 (it cannot solely be your primary residence).
- The useful life of the property is determinable. This means that the property 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. For this reason, wholesaling and house flipping, two popular real estate investment strategies, do not qualify for property depreciation.
Clearing, planting, and landscaping are all classified as part of the cost of the land, so they do not qualify as part of residential rental property depreciation.
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, does 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 to be 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 haven’t entirely made back the property’s cost. 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. Although, that doesn’t mean you don’t want to be speedy; you still want to have a quick rental property turnover.
How Should I Determine the Appropriate Depreciation Method?
There are three considerations when calculating the tax 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), an accounting formula that spreads costs over 27.5 years. That’s the number of years the IRS considers as 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. The last category is pretty broad, considering you can invest in real estate with zero to poor credit. 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
- The 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. You must determine the cost of the land and the residential property’s cost and subtract one from the other. You can use the fair market value of each at the time of purchase or 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 house’s purchase price 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 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.
- Tax-exempt bonds finance your property.
- 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 to arrive at your rental property tax deduction. If an asset valued at $1,000 is depreciated 25% yearly, then the deduction is $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 determine that tax benefit:
- 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 taking the property’s cost and dividing it by 27.5. The only difference in this example was that the property was used for only part of the first year.
How Much Does Depreciation Reduce Tax Liability?
Usually, you report your rental income and rental expenses on Schedule E’s appropriate line, 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?
Tax 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 is also where you 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 improvement cost 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 taxes is overlooking depreciation. Many 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.
What is Depreciation Recapture tax?
The total amount you save thanks to depreciation is considered a form of income by the IRS. So, the IRS taxes the amount you depreciate. This tax is called “depreciation recapture.”
What is bonus depreciation?
Bonus depreciation is one of the top landlord property tax deductions. It’s a tax write-off that lets qualifying items be entirely depreciated at the time of purchase. It’s an automatic write-off made using Form 4562, so if you don’t want to make use of bonus depreciation, you’ll need to opt-out. Why would you want to opt-out? One reason is that the legal entity you choose for your real estate investment business will play a role in how you file your taxes.
Bonus depreciation is an all or nothing tax-write off, which means that the bonus depreciation is applied to the entirety of an asset class. If you bought ten computers, then all 10 of them will be subjected to depreciation. You will have to pay depreciation recapture on items that benefit from bonus depreciation.
There’s also the Section 179 deduction, which is sometimes confused with bonus depreciation since they’re both filed using Form 4562. Both also allow you to deduct an item’s cost in the year of its purchase. Section 179, however, can only be applied when your business entity makes a profit, whereas bonus depreciation does not.
So, if you make $10,000 and your item costs $15,000, you will have $5,000 that can’t benefit from a Section 179 write-off. Although you can write off the rest later. To see if your item qualifies, visit the official website of Section 179
Bonus depreciation used to only let you write off 50% of your item’s cost, but after the Tax Cuts and Jobs Act of 2017 (TCJA), it was raised to 100%. Bonus depreciation will remain at 100% until 2023, at which point it will go down 20% each year until 2027, at which point it will cease to be (unless the federal government decides otherwise).
More detailed information can be found on the IRS’s dedicated bonus depreciation and Section 179 website.
How Does Depreciation Affect Selling?
There is one sizable drawback to depreciation. If you take depreciation deductions every year, your property’s cost basis 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. That means paying more taxes because a higher capital gain is assumed.
What you can do, however, is a 1031 exchange. This will get you out of paying capital gains tax! 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 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. You could even, which means it can help you ride out hard times.