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One of the most touted benefits of owning rental property is a reduced income tax bill.  But how exactly does that work?  One great way to pay less in taxes is to depreciate your rental property.   

Properties, without any repairs, have a limited lifespan.  As they deteriorate under wear and tear, the theoretical value of the building and its components gradually decreases.  To offset this (again, theoretical) decrease in value and the initial purchase price of your rental property, the IRS allows you to claim depreciation.  In the real world, of course, property owners make regular repairs and updates (the costs of which are also tax-deductible), but landlords can still claim depreciation on their tax returns – what’s known as a “paper expense” rather than a “real expense”.

Here are the basics in order to improve your understanding of rental property depreciation before you invest.

Is My Property Eligible?

In order to depreciate a property, it must meet specific eligibility requirements.  They include:

  • You must own the property.
  • You must use the property to produce income, such as rent.
  • The property must have a determinable useful life (meaning it must be something that eventually wears out such as a building – the land itself does not qualify).
  • The property must be expected to last more than one year (temporary shelters don’t qualify).

What Does Rental Property Depreciation Do?

Once you have determined your property is eligible, it’s important to understand what depreciation does. 

Depreciation lets you deduct your capital costs – the original cost of the rental property itself, along with other specific expenses – from your income taxes.  The IRS does not allow you to claim the entire purchase price the year you buy.  They do, however, allow you to claim a percentage of the purchase price every year.  This can represent thousands of dollars per year in tax savings. 

How To Calculate Depreciation?

In the United States, the amount of depreciation you can claim is established by the IRS.  Most residential rental property owners must use the MACRS (Modified Accelerated Cost Recovery System) to calculate depreciation.  With this system, you choose your property’s class, which then determined your depreciation period.  For residential rental investments, depreciation is usually over 27.5 years.

Let’s look at an example to see how to calculate the rental property depreciation. 

In May, you bought an income property for $120,000 and put it up for rent the same month.  The land is evaluated at $20,000 and the building at $100,000.  Since land doesn’t get used-up, you may only depreciate the cost of the building.

The next step is to find the correct percentage in the IRS’ Residential Rental Property Table.  For year one, you must use the rate for the month your rental was placed into service (in our example, it was in May as you listed the property for rent right away).  This gives you a partial depreciation amount for the first year, since you did not own it for the entire year.  The IRS table is available here.

The formula to calculate depreciation is: 

Real Estate Depreciation Tax DeductionBuilding Cost x Rate = Depreciation Amount

Year One Calculation (using the May rate of 2.273%)

$100,000 x 2.273% = $2,273

For year two and beyond, the rate is always the same, at 3.636%.  The depreciation for our property would therefore be:

$100,000 x 3.636% = $3,636

For the following years, you would be able to reduce your taxes owing by $3,636, as long as you still own the property and use it to create income.  Rental property depreciation can get quite complex.  Your original purchase price may need to be adjusted to include qualifying costs, credits or real estate taxes.  As you renovate your property or replace appliances, you may need to adjust your formula to include the changes, therefore depreciating the new costs.  It’s wise to seek professional advice when dealing with depreciation.

What’s the Catch?

There’s always a catch.  In the United States, rental property depreciation lowers your original purchase price – often called your tax basis – for tax purposes.  When you sell, the depreciation is recaptured and taxed at a higher rate than capital gains.  Even if you never claim depreciation, you’ll still owe the taxes on the recapture amount upon selling, so always claim the depreciation amount every year.

What Happens When I Sell My Rental?

If you sell your rental property, you must stop claiming depreciation, even if you have not fully recovered your purchase cost.  Once you sell, you will need to pay taxes on your capital gains (the difference between the purchase price and selling price) as well as your depreciation recapture.

Where Can I Get More Information On Depreciation?

Since every situation is different, it’s best to consult a professional for advice.  A tax accountant or CPA can guide you through the complex system of rental property depreciation and real estate tax deductions.

For more information, please see the IRS article A Brief Overview of Depreciation as well as the more detailed publication Depreciation of Rental Property.

Related Reading:

The Ultimate Landlord's Guide to Rental Property Deductions

Want to Join the Top 20%? Invest in Retirement Accounts & Rental Properties

An Overview of 1031 Exchanges & How They Defer Taxes on Real Estate Profits

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Categories: Tax Strategies

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