You are undoubtedly here today to widen your horizon on the concept of “depreciation in rental property.” Of course, rental property depreciation occurs over the useful life of the property as determined by the IRS’ depreciation method.
We’ve all heard of real estate investors with a lot of rental income and wealth but pay almost no taxes. One way for rental property owners to significantly reduce their tax liability is to maximize their tax deductions with depreciation on their assets.
What is rental property depreciation?
The IRS estimates that a residential rental property will have a useful life of 27.5 years in 2020. During that time, the property wears out – or depreciates – at least for tax purposes.
If you are a real estate investor, you can deduct 3.636% (100% / 27.5 years) of the property’s cost basis from your annual income to reduce the amount of income subject to tax.
Do you have to depreciate rental property?
In short, you are not required by law to depreciate rental property. On the other hand, choosing not to depreciate rental property is a huge financial mistake. It’s the same as throwing away a percentage of your rental property profits.
This is not a hyperbole. Property depreciation allows you to deduct a percentage of the property’s value as a tax deduction for over 27 years. Making the decision to forego the tax savings would be insane.
Here’s another way of looking at it. Would you fill out a few forms correctly if someone told you that you could save thousands of dollars annually?
Choosing not to depreciate your property is the same as choosing not to save thousands of dollars per year, which a seasoned buy-and-hold investor would never do.
Depreciation in rental property rules
However, not all rental property components can be depreciated.
For example, because the value of the land or lot does not depreciate, it cannot be depreciated. Operating expenses like property management fees, routine maintenance, and property tax are not depreciated. They are instead deducted from gross rental income in the year they occur.
Several criteria are listed in IRS Publication 527 that must be met to depreciate rental property:
- You must be the owner of the property.
- Property must generate income, usually from tenants.
- The property’s useful life must be determinable, so the land cannot be depreciated because it is never used.
- The property must have a useful life of at least one year.
Because the property has been held for less than a year, real estate investors who fix and flip cannot depreciate it.
Wholesalers can also not claim a depreciation deduction because they never actually own the real estate they are selling.
How to calculate your cost basis
Your cost basis includes the purchase price of the property as well as any additional expenses. Unlike the market value, the cost basis used for depreciation purposes does not include the value of the lot or land.
Because land is not subject to wear and tear, according to the IRS, it is not depreciable.
For example, if you paid $150,000 for a rental property in a nearby subdivision with a $20,000 lot value, your beginning cost basis is $130,000.
You should also include additional allowable costs, such as closing fees or improvements. Remember that the higher the cost basis, the higher your non-cash annual depreciation expense and the lower your taxable income.
Other costs that could be used to increase your cost basis on your tax return include:
- Legal fees, such as the cost of an attorney reviewing the purchase contract when you purchased the property
- Fees for recording or escrow
- Costs of a property survey, a septic inspection, and an environmental inspection
- Most states and municipalities levy transfer taxes, either as a flat fee or as a percentage of property value. From 2018, a state-by-state preview based on MidPoint.
- The cost of title insurance
- Debts assumed by the buyer from the seller, such as an invoice from a contractor for updating previously completed work that is being paid for over time.
Which Property Is Depreciable?
The IRS states that you can depreciate a rental property if it meets all of the following criteria:
- You own the land (you have considered the owner even if the property is subject to a debt).
- You use the property in your business or as a source of income.
- The property has a determinable useful life, which means it wears out, decays, is used up, becomes obsolete, or loses value due to natural causes.
- The property should last for at least a year.
- Even if the property meets all of the above criteria, it cannot be depreciated if it is put into service and then disposed of (or no longer used for business purposes) in the same year.
- Land is not considered depreciable because it is never “used up.
In general, the costs of clearing, planting, and landscaping cannot be depreciated because they are considered part of the cost of the land rather than the buildings.
When does rental depreciation Start?
You can take depreciation deductions as soon as you put the property into service or when it’s ready to rent.
Real Estate depreciation example: On May 15, you purchase a rental property. You’ve been working on the house for several months, and it’s finally ready to rent on July 15, so you start advertising online and in the local papers.
You find a tenant, and the lease starts on September 1. Because the property was placed in service—that is, ready to be leased and occupied—on July 15, you would begin depreciating it in July rather than September when you begin collecting rent.
You can depreciate the property further until one of the following conditions is met:
- You have deducted the entire cost of the property or other basis in it.
- You deactivate the property even if you have not fully recovered its cost or other bases. When you no longer use a property as an income-producing property—or if you sell or exchange it, convert it to personal use, abandon it, or destroy it—it is retired from service.
You can continue to deduct depreciation on property that is temporarily “idle,” or not in use. If you make repairs after one tenant leaves, you can continue to depreciate the property while preparing it for the next tenant.
Rental Property Depreciation Method
The IRS expects you to follow certain rental property depreciation rules. The MACRS, which spreads costs and depreciation deductions over 27.5 years for residential properties and 39 years for commercial properties, is one of them. Keep in mind that we are using the MACRS GDS rather than the ADS.
Let’s take a look at the MACRS formula, which is the asset’s cost basis multiplied by the depreciation rate. The cost basis is the same as the property’s purchase price. You can determine which depreciation rate to use by consulting one of the three tables provided by the IRS in Publication 946.
MACRS Formula Using GDS = Cost basis of the asset x Depreciation rate
Residential Rental Property Depreciation Recapture Example
We’ll walk you through six steps to calculate depreciation recapture. First, we must determine the property’s tax basis, which is equal to the purchase price plus any closing costs and capitalized expenses. We also require the adjusted cost basis, which is the purchase price less annual depreciation multiplied by the number of years of ownership.
Now, in six steps, let’s look at a rental property depreciation recapture example.
1. Invest in a Rental Property
Assume Jane paid $350,000 for a residential income producing property. Assume the property has a $20,000 annual depreciation and Jane decides to sell it after 11 years for $430,000.
2. Determine the Rental Property’s Adjusted Cost Basis.
The adjusted cost basis is calculated by subtracting the purchase price from the annual depreciation rate and multiplying it by the number of years of ownership, yielding $130,000.
$350,000 – ($20,000 x 11) = $130,000
3. Determine the Rental Property’s Realized Gain
The realized gain on the property is then calculated by subtracting $130,000 from $430,000, yielding $300,000.
4. Determine the Rental Property’s Capital Gain
The capital gain will be $300,000 minus ($20,000 x 11), or $80,000, and the recapture gain will be $20,000 x 11, or $220,000.
5. Understand Your Tax Brackets
Let us now assume a 20% capital gains tax and a 28% income tax bracket. Jane’s total tax on the rental property will be (0.20 x $80,000) + (0.28 x $220,000) = $16,000 + $61,600 = $77,600.
6. Determine the Amount of Depreciation Recapture
The depreciation recapture amount is calculated by multiplying your tax bracket, expressed as a percentage, by the recapture gain of $220,000. The amount of depreciation recaptured will be $61,600.
The above example is complicated, but you calculated the depreciation recapture amount.
So, now that you know how much you will pay to sell a property, you can decide whether it is worth selling and how much you need to sell it for.
The depreciation in rental property provides a tax deduction that can be claimed under Internal Revenue Service Schedule E. As a result, this aids in the individual’s tax planning.
The owner can no longer claim depreciation on the rental property once it has been sold. Depreciation is a non-cash expense that can be used to offset tax liabilities, and it is a simpler way to record the asset’s cost on the income statement.