If you own a rental property, your mind should be constantly geared toward getting the most money possible out of your investment. The monthly cash flow you enjoy from rental income, the increasing value of your property as it appreciates, and the continual reduction of operating expenses are just a few of the ways you can make sure your investment is as profitable as it can be.
Tax deductions are also a key way landlords get the most out of their rental property investments. Everything from insurance, repairs, maintenance, marketing, office expenses and more can be deducted to create considerable savings when tax time rolls around. In addition, rental property owners can take a rental property depreciation deduction each year.
What Is Rental Property Depreciation?
The accounting term “depreciation” refers to the way an asset loses value over time. If a business owns the asset, depreciation can be used to pay for it over time instead of covering the entire cost the moment they acquire it.
The company can reduce its taxable income when taxes are due by taking a deduction for the purchase price of the asset. Their income statement will reflect this depreciation expense as a debt. The company’s balance sheet will record the accumulated depreciation as a credit.
Owners of rental properties can use this strategy to improve balance sheets and tax deduction calculations. However, they have to show the IRS that their property’s useful life can be calculated.
So, how do you determine the useful life of a rental property? This might seem difficult given the varying types of rental properties that exist. “How can a 75-year-old property compare to a brand new building?” you may ask. The answer is actually quite simple.
The IRS has created guidelines to help you determine the useful life of a rental property, and thus, the depreciation you can claim on your taxes. According to the guidelines, the useful life of a residential property is 27.5 years. For commercial properties, the useful life of a property is 39 years. For rental property purposes, it’s important to note that a 1 to 4 unit building is considered residential property and a 5 or more unit building is considered a commercial property.
How To Calculate Depreciation On A Rental Property
The rental property depreciation process has four basic steps that include determining the cost basis of your property, adjusting your cost basis, dividing the cost basis by your property’s useful life, and calculating a depreciation schedule. Let’s dive deeper into each of these terms and how to calculate rental property depreciation.
Calculating your cost basis involves determining the monetary value of your rental property as well as some of the closing costs associated with completing the sale when you purchased it. If you purchased your rental property as an investment property, the value is simply what you paid for it. If you converted your primary residence into a rental property, you will need an appraisal to determine the monetary value.
The closing costs that can be added to the value of your rental property to determine the cost basis include:
- Utility Installation: The costs of installing gas, electric, water and other utilities.
- Title Abstract Fees: The fee the title company charges you at the closing for a written description of the rental property you are purchasing. /
- Recording Fees: All real estate transactions must be recorded by your local municipality and they charge a fee.
- Legal Fees: If you used an attorney to buy your rental property, they likely charged you a fee.
- Property Taxes: If you paid for the seller’s real estate taxes when you bought your rental property it can be added to your cost basis.
- Back Interest Payments: If you paid for the seller’s back interest payments when you bought your rental property it can be added to your cost basis.
- Agent Commissions: If you paid for any real estate agent commissions during the purchase process, you can add them to your cost basis.
- Survey: If you had a survey done when you purchased your rental property to determine the property boundary, you can add the cost to your cost basis.
Once you add all the applicable costs outlined here to your property’s monetary value, you have determined your cost basis.
Buildings and Land
It’s important to note that buildings can depreciate but land cannot. As a result, you need to separate the value of the land you own from the value of the rental building you own to find your cost basis.
If you know the fair market value of the building and the land when you bought the rental property, simply use the value of the building for your cost basis. If you don’t know what was the fair market value of each when you bought the property, you can use the amount assessed in the tax records.
As an example, let’s say you purchased a rental property for $300,000 and you find out from the tax assessment that the value of the property is $280,000 ($250,000 for the building and $30,000) for the land.
So, 89 percent ($250,000 divided by $280,000) of your sale cost ($300,000) would be your cost basis for the building. This would come out to $267,000 (89 percent of $300,00).
Adjusted Cost Basis
Once you have figured out the initial cost basis, you need to adjust it. Depending on a variety of factors, your cost basis may increase or decrease once the necessary adjustments are made. Renovations, repairs, or additions you paid for before renting the property can be added to your cost basis. Legal fees can be added as well.
If you received insurance payments for loss, theft, or damage to the property, those need to be subtracted from your cost basis. If you got paid to grant an easement (letting a neighbor use your property for a driveway to their land, for example), that needs to be subtracted as well.
Example Of Rental Property Depreciation
Let’s use an example to illustrate how rental property depreciation works. Using the 27.5 useful life span guidelines outlined by the IRS, you can calculate equal depreciation for each full year your rental property is actively renting units. This is 3.63% per year. Keep in mind that you will need to prorate the percentage based on the month you purchased the property and started renting it:
So, if you bought a rental property this June with a cost basis of $267,000 and started renting it right away. For this year, you would depreciate at a rate of 1.970%, or $5,260 (1.970 percent of $267,000). For each subsequent year, you would depreciate at a rate of 3.636%, or $9,708 (3.636 percent of $267,000).
Do You Have To Depreciate A Rental Property?
No, you are not required to depreciate a rental property. However, there is no good reason not to. Failing to depreciate your rental property is essentially throwing away a percentage of your rental property income each year.
What Happens To Depreciation When You Sell a Rental Property?
When you sell a rental property, you will undergo “depreciation recapture.” This means that you will be taxed at your usual income rate (selling a property is considered income). The maximum you can be taxed with depreciation recapture is 25 percent.
What Happens To Depreciation During A 1031 Exchange?
A 1031 exchange allows you to defer your depreciation recapture by acquiring another rental property. Essentially, you avoid getting taxed for income because you are reinvesting the funds from a sale into another property.
Rental Property Depreciation Rules
Now, let’s dive into the rules of rental property depreciation so you can decide if you qualify. First, and perhaps obviously, you must own the property. Second, the rental property must provide you with income. Third, you must be able to determine the useful life of your rental property. This is possible for nearly all rental properties, given the clear guidelines established by the IRS. Finally, the useful life of your rental property must be more than a year.
Getting the most out of your rental property investment should be your top priority as an investment property owner. This means having a complete understanding of all the financial tools available to you. When tax time comes around each year, remember that you have rental property depreciation in your financial toolbox.