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If you’re considering a real estate investment opportunity, rental property depreciation is one of the most useful hacks to know about.
This is a critical tool that you can use to deduct the costs of buying and maintaining your property — potentially leading to significant savings over the course of your investment and more favorable tax returns along with it.
It can also potentially lower the entire cost of a real estate investment. Doesn’t sound too bad, does it?
This post explores what rental property depreciation is, how it works, and the benefit of using it to lower your tax liability.
Annual depreciation: A guide for real estate investors
The IRS recognizes that buildings require a lot of maintenance and tend to degrade over time. It’s only a matter of time before residential rental property owners need to rip up and replace the carpeting and install new windows, after all.
At the same time, buildings often become outdated. For example, lighting fixtures or even appliances can go out of fashion. You need to update these types of things from time to time for a property to maintain its value — and for you as an investor to keep cash flow running smoothly.
As a result of all this, the Internal Revenue Service (IRS) lets you spread the cost of some assets over their entire useful life expectancy — instead of all at once when you buy a property.
Qualifying for depreciation tax benefits
Unfortunately, just because you own a house doesn’t mean that it’s automatically eligible for depreciation benefits. There are some rules that you have to follow, which we’ll briefly examine next.
1. You own the property
You can’t claim a depreciation benefit on a property you don’t own. You have to be the sole proprietor of the property. In other words, you can’t rent or sublet a property from someone else, put it on Airbnb, and claim a depreciation credit. That would be committing tax fraud.
2. The property is an investment
You also can’t claim a depreciation tax on the house that you live in. It has to be an investment property, meaning you purchased it with the goal of profiting from it.
3. The property will last more than a year
A depreciation tax is for long-term investing. In other words, you can’t claim an income tax benefit on a property you intend to sell within a year. You have to buy the property with the intention of holding it through at least the first year to claim a depreciation tax benefit.
4. It must have a determinable useful life
The property must be a sound structure like an apartment building or a single-family or multi-family house. In other words, it can’t be of questionable structure or form, like a hut or a treehouse. The property must be of sound design with obvious uses.
What is depreciation recapture?
Depreciation recapture refers to the gain resulting from the sale of depreciable property.
This occurs when an asset’s sale price is more than the adjusted cost basis or tax basis. When this happens, you’ll report the property as ordinary income to the IRS on form 4797.
In short, depreciation enables the IRS to collect taxes on an asset that was previously used to offset taxable income.
To determine the amount of depreciation recapture, compare the asset’s cost basis to the sale price.
Examples of depreciable property
Depreciable property can extend beyond a building itself.
It can include tangible property, like vehicles and equipment like computers or technology. It can also include intangible assets like copyrights, software, and patents.
That said, there are some restrictions. For example, you can’t depreciate land or collectibles like art. It’s also against the rules to depreciate personal property (e.g., clothes or a car you drive for non-work purposes).
Single vs. multi-year expenses
Not all types of expenses qualify as depreciation on your rental real estate property. For example, snow removal or sealing your concrete is most likely considered a single-year expense, meaning you’ll pay for them at one time instead of repeatedly over a period of time. Other examples of single-year expenses include mortgage insurance, property taxes, and operating expenses as well as other small repairs.
However, suppose you want to add a new deck or replace your floors. In this case, you would determine the lifespan of these investments and spread the cost over the course of many years.
Talk to a tax advisor if you have any questions about what constitutes a small repair versus a larger one to determine whether you can take the depreciation expense and reap the associated tax advantages. This is not something you want to guess about, as the wrong decision could raise a red flag to the IRS.
How to calculate real estate depreciation
To calculate depreciation, you’ll need to determine the perceived decrease in the value of a property over a period spanning 27.5 years.
Use the following formula to determine depreciation on your rental property:
- Find the cost of the building or how much you paid for it.
- Subtract the value of the land from the cost of the building to determine your building value.
- Divide your building value by 27.5 to get your yearly allowable deductible depreciation amount.
Know the difference: ACRS vs. MACRS
There are two types of depreciation systems in the U.S. used for tax purposes: the Accelerated Cost Recovery System (ACRS) and the Modified Accelerated Cost Recovery System (MACRS).
The ACRS is for depreciating property placed in service between 1980 and 1987. For this system, depreciation depends on recovery periods predetermined by the IRS. Unlike other situations, it doesn’t go by useful life.
The MACRS is for property placed in service after 1986. This system replaced the ACRS and uses the straight-line method and declining balance method to determine depreciation.
Real estate investor vs. professional
The IRS also makes a clear distinction between passive real estate investors and professional real estate investors.
Most people fall in the first category. In short, this means you have a full-time job and own property that produces gains. People in this category can’t offset ordinary income from their employment unless their modified adjusted gross income is less than $100,000. In this case, it’s possible to offset ordinary income up to $25,000 through passive income loss.
To qualify as a real estate professional, you must provide more than one-half of your total personal services in real property trades and perform more than 750 hours of services in that line of work annually.
Tips for rental property tax deductions with real estate investing
Work with a tax professional for rental property depreciation
The rule of thumb is to trust a tax professional when calculating rental property tax deductions. Trusting a professional can ensure that you claim accurate deductions and don’t break any rules. It also puts you in the best position to maximize your savings.
Attempting to do rental property taxes on your own is a risky decision. Even if you generally know your way around taxes, it pays to work with someone who has a thorough understanding of the ins and outs of tax law and can help you move to a lower tax bracket the right way.
Get a cost segregation study
It’s a good idea to conduct a cost segregation study whenever you buy a new investment property. This involves allocating value away from the building and into the multiple components that make up the building.
By breaking down the value of a property with useful life into 5, 7, 15, and 27.5-year time frames, you can write off individual items at a faster rate. For example, a freezer or air conditioning unit probably won’t last 27.5 years. A cost segregation study is important because it can help increase your depreciation deductions over a shorter time period.
Consider a 1031 exchange
Once your 27.5 years have expired, you will not be eligible for any further depreciation tax credits. At this point, you should look into a 1031 exchange.
A 1031 exchange is a transaction that involves trading a real estate investment for a property of equal or greater value. For example, you can take an apartment building and trade it for a portfolio of smaller individual condos or houses that are equal to or less than the value of the property.
In doing so, you could defer all capital gains taxes on the sale of your place, providing much-needed relief to you as a taxpayer. It’s also a way to diversify your portfolio and protect your wealth.
Frequently Asked Questions
When does the depreciating period start?
Depreciation deductions can begin as soon as service starts on the property and it’s available to rent.
Check with your tax advisor or CPA for the exact time when you can start claiming depreciation so that you don’t incur any rental expenses that you can’t write off. Timing is key here. If your goal is making money on your investment, the last thing you want is to incur charges you can’t write off.
Is land depreciable?
Land is not depreciable because it doesn’t get used. The value of the land is different from the value of the house.
What’s more, you can’t count work that you do to the land like clearing or landscaping as a depreciable expense. Those costs center around land management — and not real estate depreciation — which is generally considered an operational expenditure.
What is cost basis?
Cost basis refers to the original purchase price of an investment or asset for tax purposes. It’s used when calculating capital gains or losses.
By determining the cost basis of an investment, you can understand whether it’s profitable — or whether you’re in the hole. And based on that information, you can understand if it comes with any tax implications.
As such, cost basis is one of the critical metrics to understand in real estate.
Do you have to produce rental income to claim depreciation?
You should always consult with a tax professional with any specific questions about what you may owe on taxes.
In most cases, depreciation credits are for investors who choose to rent their property for tenants. It would be hard to justify buying a property, calling it an investment, and not renting it or flipping it within a short window of time.
However, you may be able to claim a depreciation credit if you buy a place, fix it up, and hold it until you anticipate that market conditions will improve. This would be a rare case that would require the advice of a tax professional.
Do you have to depreciate rental property and write off expenses?
You are not technically required to claim a depreciation tax credit. However, you do need to recapture depreciation when you someday decide to sell the property. As such, you can’t get around the depreciation issues altogether.
Do you have to report rental income?
Tax law requires you to report rental income to the IRS. If you fail to report rental income to the IRS, they can use a failure to pay penalty at a rate of 0.05% per month, which cannot exceed 25% of the total tax that you owe.
Remember that you have to pay taxes if you owe the IRS. There’s no way around it. If you don’t pay, it’s going to eventually catch up with you and the results could be catastrophic. Just ask Wesley Snipes.
The Bottom line
Few people really enjoy sifting through page after page of the tax code and studying things like depreciation. However, understanding it and applying it to your tax situation could be the difference between a successful and unsuccessful investment. If you’re putting money into real estate, it’s absolutely something that you have to be aware of.
Best practices call for working with a tax advisor during this process. If you tend to be lazy about writing things off, a tax advisor can help you keep more money in your pocket. And if you tend to push the limits, a tax advisor can rein you in and keep you out of trouble with the IRS.
At the end of the day, you need to remember that (most likely) you’re not a tax professional. And chances are likely you’re not even a full-time real estate investor. You’re an amateur, and amateurs need to rely on professionals to help them navigate things they don’t understand.
Even the most successful real estate investors work with tax advisors. As you begin building your real estate empire, seriously consider enlisting the services of a seasoned professional who can help you optimize your real estate taxes on the road to financial independence.