Investing in a rental property is a great way to earn extra income, but it’s essential that you understand the different tax implications of owning a rental property. For example, one of the key tax benefits of owning a rental property is that you can depreciate the cost of the property over time.
Rental property depreciation is based on the idea that any physical asset will eventually deteriorate and become less valuable over time. The IRS allows real estate investors to write off a portion of this each year as a way to offset the wear and tear of the property.
However, it’s worth noting that depreciation doesn’t apply to the land itself – only the buildings on the property. With that in mind, the following is everything you need to know about the basics of rental property depreciation.
What Is Rental Property Depreciation?
When you buy a property, it has a determinable useful life. If you don’t invest in things like routine maintenance, repairs, and renovations, then your property will slowly become worth less and less. Not only will it lose value, but it will become more difficult to find tenants.
The IRS understands this, which is why they allow rental property owners to make a depreciation deduction. This deduction allows you to write off a portion of the cost of your property each year, as a way to offset the wear and tear of the property. However, there are some conditions that must be met to take advantage of the depreciation deduction.
Conditions For Claiming Depreciation
The following are the conditions that you must meet to be able to claim depreciation on your rental property:
- You must own the property: You must own the property to claim depreciation. As such, you must have paid for the property in full, or at least have made a significant down payment.
- The property must be used for business or income generation: The property must be used for business or income generation, which means that you can’t claim depreciation on your personal residence.
- The property must have a determinable useful life: The property must have a determinable useful life, meaning that it will eventually need repairs or replacement.
- The useful life of the property must be longer than one year: The useful life of the property must be longer than one year. It’s worth noting that you can’t claim depreciation on assets with a useful life of less than one year. For example, if you buy a house then sell it the same year you bought it, then you can’t claim depreciation on it.
Why You Should Claim Depreciation On Your Property
There are a few key reasons why you should claim depreciation on your rental property. Doing so can help offset the cost of repairs and renovations, which will be required over the years to keep your rental property in good condition. Additionally, it can help you save a significant amount of money on your taxes. Other advantages include:
Tax Claim Advantages
The main advantage of claiming depreciation is that it lowers your taxable income. As a result, you’ll owe less in taxes each year. The amount of money you save on taxes will depend on your tax bracket.
Reduced Tax Liabilities
Another advantage of claiming depreciation is that it’s a paper loss. This means that you can use the losses to offset other gains on your taxes.
For example, let’s say that you have a rental property with an annual depreciation deduction of $5,000 and you also have a capital gain of $5,000 on a different asset. This means that you’ll owe no taxes on the capital gain because it can be offset by the loss from depreciation.
When Does Depreciation Start?
Just because you’ve purchased a rental property doesn’t mean you can immediately begin claiming depreciation. You won’t be able to claim the deduction until the property is officially available to rent. Depreciation begins as soon as you begin looking for tenants.
Depreciation will continue even when the rental property is vacant in between tenants, and only stops if you’ve either deducted the entire cost basis (the original value or purchase price of the property) over the course of the 27.5 year limit, or you’ve stopped using the property to generate income (even if you haven’t recovered the cost of the property).
For example, if you purchase a rental property on January 1st and it’s available for rent on February 1st, you can begin claiming depreciation on February 1st.
The amount of time that has elapsed since you purchased the property doesn’t matter. As long as the property is available for rent, you can begin claiming depreciation.
Can Investment Assets Depreciate Too?
The simple answer is “yes.” You can depreciate most anything that you purchase for business or investment purposes. Different components of a rental property have a faster depreciation rate, which means that you can depreciate them separately from the property. The following are a few examples of rental property assets that can be depreciated separately:
- Appliances: You can depreciate the cost of appliances over a five-year period. This includes refrigerators, ovens, dishwashers, and any other appliance that you purchase for your rental property.
- Carpeting: You can depreciate the cost of carpeting over a five-year period. This includes any carpeting that you install in your rental property, whether in the units or common areas.
- Furniture: You can depreciate the cost of office furniture over a seven-year period, and furniture used in a fully furnished rental property over a five-year period. This includes couches, chairs, tables, and any other furniture that you purchase for your rental property.
- Roads and fences: You can depreciate the cost of roads and fences over a 15-year period. This includes any roads or fences that you construct on the property, as well as the cost of maintaining them.
Depreciation Systems You Can Use
If you purchased a rental property after 1986, then you must use the Modified Accelerated Cost Recovery System (MACRS) to calculate your depreciation deduction. The MACRS works by dividing the cost of the property into categories, each with a different depreciation rate.
Under this system, you must depreciate your property over a 27.5-year period. This is the life expectancy of a residential rental property, as set by the IRS. For commercial rental properties, the period is 39 years.
The MACRS has two methods: the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). The GDS is the most common method and is used unless you elect to use the ADS.
General Depreciation System (GDS)
The General Depreciation System is the most commonly used system. The GDS uses the declining balance method, where you deduct a larger amount of depreciation in the early years and a smaller amount in the later years.
Alternative Depreciation System (ADS)
The Alternative Depreciation System is an optional system that you can use if you meet certain criteria. The ADS uses the straight-line method. This means that you deduct the same amount of depreciation each year for the life of the asset. If the property was placed into service after December 31, 2017, then the recovery period is 30 years instead of 27.5.
It’s worth mentioning that if your property meets certain criteria, you must use ADS. This criteria is as follows:
- The property has a qualified business use 50% of the time or less
- The property is used mostly for farming purposes
- The property has a use that is tax-exempt
- The property is financed by tax-exempt bonds
Computing Depreciation On Rental Property
You’ll need a lot of information to be able to accurately calculate the depreciation on your rental property. To compute your depreciation deduction, you’ll need to follow these steps:
Step 1: Determine The Basis Of The Property
The basis of your property is the amount you paid for it (including any loans that you took out to pay for it). There are some purchasing costs that you can include in the basis of the property as well, including closing costs such as recording fees, legal fees, and title insurance. However, not all closing costs (such as appraisal fees or mortgage insurance premiums) can be included.
Step 2: Separate The Cost Of The Land And The Buildings
You can’t depreciate the cost of the land your rental property is built on – you can only depreciate the cost of the buildings. As such, you’ll need to determine the separate values of the land and the buildings of the property you purchased.
Step 3: Determine The Amount That Can Be Depreciated
The next step is to determine how much of the basis can be depreciated. For example, if you purchase a rental property for $100,000 and the land it’s built on is worth $20,000, then your basis for depreciation would be $80,000.
Step 4: Determine The Adjusted Basis, If Necessary
If you’ve made any capital improvements to your rental property, you’ll need to determine the adjusted basis. The adjusted basis is the original basis of the property, plus the cost of any capital improvements.
For example, if you purchased a rental property for $100,000 and made $20,000 in renovations, then your adjusted basis would be $120,000. In some cases, you may need to subtract costs from your basis, such as any collected insurance payments as a result of damage to your rental property.
What Happens When You Sell Your Property
If you sell your property, you’ll need to take the depreciation on the property into account. When you sell the property, any depreciation you’ve taken will be considered “recaptured” and will be taxed as ordinary income.
For example, if you sold a rental property for $200,000 that you originally purchased for $100,000 and took $5,000 in depreciation each year, you would need to pay taxes on the $50,000 of depreciation you recaptured over that time period.
You’ll want to keep this in mind if you’re thinking about selling your rental property down the line. The following is a more detailed breakdown of how this works:
Depreciation Leads To Cost Basis Decline
The tax basis of your investment property is important for figuring out how much profit you make (or loss you incur) when you sell. You can calculate your tax basis by subtracting the total of your depreciation deductions from the original purchase price.
The lower your tax basis, the more tax you’ll have to pay on your profit when you sell. This is because depreciation reduces your cost basis, which results in more taxes when you eventually sell the property – but remember, you get an annual tax deduction in the meantime.
How To Get Out Of Paying More Taxes On A Depreciated Property
If you’re selling a property that has appreciated in value, you may be able to avoid paying taxes on the depreciation by doing a 1031 exchange.
With a 1031 exchange, also known as a like-kind exchange, you can sell an investment property and use the proceeds to buy another investment property without paying taxes on the sale. The IRS has strict rules about what type of property qualifies for a 1031 exchange, so be sure to consult a tax advisor before you try to do one.
You Can Make Depreciation Work To Your Advantage
Depreciation is an important tax deduction strategy for rental property owners. By understanding how to claim depreciation, you can minimize the amount of taxes you owe on your rental income and offset the costs of repairing and renovating your property.
However, it’s also important to keep in mind how it can impact your taxes when you eventually sell the property. By understanding how depreciation works and keeping track of your tax basis, you can make sure you’re prepared for tax time.