Although you may not look forward to tax season, being a rental property owner has some major benefits, like depreciation. This type of deduction lowers your total taxable net income as your property ages.
In this guide, we will explore depreciation in depth, so you can confidently manage your property year-round.
What is depreciation in real estate?
Depreciation shows how much of an asset has been used.
In reference to real estate, depreciation allows property owners to lower their tax burden by deducting the cost of buying and upgrading their property over a period of time.
The tax write-off for depreciation occurs over the period of your property’s useful life — the amount of time it is expected to generate revenue.
The IRS uses useful life estimates to calculate depreciation rates for various types of assets. A rental property’s useful life can be influenced by factors like its age at the time of purchase and upgrades made to it over the course of ownership.
Rental property depreciation assumes that your property’s value will lower over time; as it ages, natural wear and tear will eventually cause it to be worth less than it was bought for. In order to keep properties modern and valuable, owners perform periodic upgrades.
The cost of these improvements can negatively impact your bottom line, so depreciation can provide tax breaks that essentially lower your cost of ownership.
What is the useful life for a rental property?
The IRS assumes a usual life of 27.5 years for residential rental properties and 39 years for commercial properties. Each year, the amount of depreciation reduces by a fixed percentage over the course of your property’s life.
Residential rental properties have a depreciation value of 3.636%, and commercial property expenses are reduced by 2.56% annually.
Factors That Affect Depreciation Value
Your depreciation value could be higher or lower than the average depending on your property. Expenses you can include when calculating your property’s depreciation include:
- Attorney fees
- Broker fees
- Escrow fees
- Closing costs
- Property survey expenses
- Inherited debts from the seller
These costs, along with the price you bought the property for, can all be used to calculate your cost basis.
The cost basis is the calculated value of your rental property that qualifies for depreciation.
Related Reading: Is Landlord Insurance Tax Deductible?
How to Calculate the Cost Basis of a Rental Property
There are two points to consider as you calculate your real estate cost basis:
- How much you paid for the property
- The cost of any upgrades you’ve made
To calculate the cost basis, you subtract the cost of major property improvements from its selling price. The end result is your depreciable basis. If you sell your property in the future, this figure determines whether it was sold at a gain or loss.
The period you can claim depreciation is called the recovery period. You can determine your annual depreciation amount by dividing your property’s cost basis and value of your property over the IRS-specified period of time, i.e., 27.5 or 39 years.
Who is eligible for real estate depreciation?
In order to write off depreciation, you must:
- Own your property or with a mortgage
- Utilize the property as a business or income-generating activity
- It must have a useful life value, meaning it loses value over time
- The property must have a useful life value longer than one year
IRS Publication 527 outlines all the requirements of residential real estate, including deductions you are allowed to write off, and how to report rental income activity on your tax return.
According to chapter 2, three factors determine your depreciation each year:
- Your cost basis
- The property’s recovery period
- The depreciation method you choose
Under IRS guidelines, owners cannot merely deduct mortgage or principal payments, or the cost of furniture, fixtures, and equipment used to upgrade or improve the property. Your depreciation is also only applicable to the portion of the property that you use for rental purposes.
For many owners, this is the entire property. However, in some cases, rental income may only generate from a particular part of the building.
The Section 179 deduction is the most common way of calculating depreciation on a rental property. You can also opt for an accelerated method, but you may be subject to alternative maximum tax (AMT).
How to Calculate Depreciation on a Rental Property
The modified accelerated cost recovery system (MACRS) is the standard method of depreciation, and there are three methods of calculating depreciation accepted by the IRS. It is used for buildings that went into service after 1986. You can also use the Alternative Depreciation System (ADS), another name for the popular straight-line method.
The straight line method, or ADS, is used for buildings that went into service after 1980 but before 1987.
Given that the majority of properties will qualify to use the GDS system, that is the framework we will discuss in this article.
General Depreciation System
According to the IRS, a property can use the GDS system if it generates 80% or more of its annual revenue from dwelling units. Mobile homes are included. Hotels, motels, or short-stay apartments with temporary housing are not considered rental real estate.
If you live on any part of the property, or use any portion for personal use, then the gross rental income includes the fair rental value of the space you occupy.
How to Calculate Calculating Property Depreciation in 2 Easy Steps
Now that we have reviewed key terms, it is time to learn how to actually calculate your property’s depreciation value. You can follow these steps to get the amount you need to save as much as possible on your annual taxes.
Step 1: Calculate Your Cost Basis
At the time of purchase, your cost basis is the total cost of your house subtracted from the value of the land it sits on.
Over time, the cost basis is the difference between the cost of improvements you’ve made from the cost basis of the house.
Keep in mind that improvements are only valid in the year they are made. You cannot use upgrades from a year or longer to increase your depreciation value in the current tax year.
Step 2: Calculate Your Annual Depreciation Amount
You can depreciate the value of your property, not its land, by dividing your building value (depreciable basis) by the property’s useful life value. To do this, you must subtract the land value from the building value, then divide the building value by 27.5.
Here is an example:
Imagine that you purchase a duplex for $450,000. The land value is $95,000. You must subtract the land value from the purchase price to calculate your building value. In this case, $450,000 minus $95,000 leaves you with a building value of $355,000.
Next, you divide $355,000 by the residential useful life value of 27.5 years. Your annual depreciation value is $12,909.
Related Reading: Can you Avoid Capital Gains Tax on a Rental Property?
How to Claim Property Depreciation
You can claim a rental property depreciation deduction on Schedule E for your Form 1040. On this form, you will enter your annual depreciation value, as well as list your property taxes, interest, and maintenance costs that you paid throughout the year.
In some cases, you may also have to complete and file a Form 4562 to complete your deduction.
What deductions can property owners take?
Landlords can write off a variety of expenses to lower their overall tax burden without reducing their cash flow. Using Form 4562, you can claim improvements.
It’s also possible for landlords to write off expenses such as:
- Operating costs
- Mortgage interest
- Property taxes
- Repairs and maintenance costs
- Certain materials, supplies, and equipment used for property upkeep
- Necessary costs for keeping the building in good condition, such as utilities and insurance
You cannot deduct improvements on their own. You can only incorporate upgrades into your depreciation if the improvements are made for the restoration or adaptation of a property.
Upgrades that count toward rental property depreciation must be major improvements, not merely cosmetic upgrades. Examples include installing or replacing ductwork and an HVAC system, incorporating a new plumbing system, and replacing 30% or more of the roof, windows, floors, or electrical system.
Think “property changing” when it comes to qualifying improvements. These upgrades must dramatically improve the functionality of the building, and support its ongoing use as a rental property.
Depreciation for rental property helps landlords reduce their taxable income and save on expenses related to operating and maintaining their building. Using depreciation on your federal tax return can save you money every year as your property ages.
The usual life of a residential rental property allows you to claim depreciation for 27.5 years, making it one of the most impactful and enduring tax saving techniques you can use.