Real estate depreciation can save you money at tax time depreciation is an important tool for rental property owners. It allows you to deduct the costs from your taxes of buying and improving a property over its useful life, and thus lowers your taxable income in the process.
How does rental property depreciation work?
When you purchase a property with the intent of having it rented out, you can depreciate the cost of land over a period of time.
There is no one-size-fits-all when it comes to the rental properties’ lifespan. The cheaply built homes are easily worn out after several years or so. While historic homes stood the test of time for a hundred years and are still considered in perfect shape.
The IRS created a guideline in terms of how real estate owners can use depreciation for their taxable income. An owner of residential rental property has an estimated useful life of 27.5 years. This means that you can divide the cost basis of your property by 27.5 years to determine the annual depreciation “expense”. Owning a commercial property has a higher depreciation period which is 39 years. Take note that only the value of the building is depreciated. This does not include the land on which the building is built. Land does not have a lifespan compared to a building. This is because land can never be “used up”. There are ways on how you can find out the value of the building versus the land it is on. Hiring a qualified and professional appraiser will help you just do that. Another way is through tax assessment. This will help separate the value of the land.
There are also several tax benefits. You can often deduct your rental expenses from any rental income you earn, thereby lowering your overall tax liability. Most rental property expenses, including mortgage insurance, property taxes, repair and maintenance expenses, home office expenses, insurance, professional services, and travel expenses related to management are all deductible in the year you spend the money.
Investing in rental property is considered a smart financial move of most if not all successful entrepreneurs. For starters, it can give you a steady source of income while you build equity in the property as it appreciates over a certain period of time. Deducting your rental expenses such as a mortgage, insurance, repair and maintenance of the rental property, home office expenses, insurance, travel expenses related to the management of the rental properties as well as professional services will help lower your overall tax liability.
A rental property owner can also deduct depreciation to the purchase price and improvement costs from your tax returns.
Depreciation begins as soon as the property has started rendering service or once it is available for usage as a rental.
Most residential rental property owners have a depreciation rate of 3.636% each year for the span of 27.5 years.
Which Property Is Depreciable?
According to IRS, you can depreciate a rental property as long as it meets the following requirements:
- You are the owner of the property even if the place is not yet fully paid
- The property is used for business to generate income
- The building has a determinable useful life. It means that it is subject to wear and tear to the point that it gets obsolete or loses its value from natural causes
- The place is expected to last for more than a year
As general rule activities or expenses such as clearing, planting, landscaping is not considered expenses for the building and therefore cannot be depreciated.
When Does Depreciation Start?
Depreciation deductions only begin when you place the property ready for generating income, needless to say, that it is available for rental. For better understanding let me illustrate it to you. You purchased a rental property on April 15 and after adding some value to the property, you decided to have it ready by July 28. To acquire tenants you decided to advertise it. A tenant spotted and liked the place. You created the lease and the tenant started renting on September 5. Depreciation starts in July which was the month that the place was ready for rent and not the month when the tenant started to rent the place.
Depreciation stops when the property has retired from providing a service or is no longer producing an income. This is even if you have not fully recovered from the entailed costs. This also includes if you abandoned the place or use it for personal.
However, for idle properties, you can still continue to claim a depreciation deduction. An example of this is making some repairs and getting it ready for the next tenant after one has moved out.
There are 3 factors that can determine the depreciation that you can deduct each year. The following are:
- Your basis in the property
- Recovery period
- Depreciation method used
A residential rental property that is placed in service after 1986 uses the Modified Accelerated Cost Recovery System (MACRS). This is an accounting method that spreads costs and depreciation deductions over 27.5 years. The number of years considered by the IRS as the “useful life” of a rental property
When computing for the depreciation, it is highly recommended to work with a qualified tax accountant, however, let me show you the basic steps:
Determine the basis of the property, which is the cost or amount you paid to get the place. This can be in a form of cash, mortgage, or in some other fashion. Some fees and closing costs like legal fees, recording fees for the transfer of taxes, title insurance, and any other amount that the seller owes are included in the basis. However, some settlement fees and closing costs that cannot be included are as follows: fire insurance premiums, rent from tenancy of the property before closing, mortgage insurance premiums, credit report costs, and appraisal fees.
Segregate the cost of the buildings and land. Remember, you can only depreciate the building and not the land. To determine the value, you can use the fair market price during the time you purchased the property or based it on the assessed real estate tax values. Assuming you purchased the house for $120,000. According to the recent real estate tax assessment values, the property at $110,000, of which $90,000 is for the house and only $20,000 is for the land. Therefore you can allocate 82% ($90,000 ÷ $110,000) of the purchase price to the house while the remaining 18% ($20,000 ÷ $110,000) is for the land.
Now that you are aware of the basis of the property (house plus land) and the value of the house, you can now compute your basis for the house. Using the examples provided the depreciation would be $98,400 (82% of $120,000). Your basis for the land is $21,600 (18% of $120,000).
Other Deductibles For Your Tax Other Than Depreciation
Depreciation is the big deduction for a rental property owner, however, there are other ways in which you can reduce taxable rental income. Other expenses can be deducted as well:
- Property management expenses
- Utilities paid by the owner
- Advertising cost for seeking new tenants
- Property maintenance (examples would be fixing toilets)
- Expenses related to obtaining and retaining tenants
- Property insurance
- Legal fees related to owning a property
Clearly, rental property depreciation is the best, if not one of the best deductions that can lead to tax savings. Reading this article can provide you a perspective of how rental depreciation can help lower your taxes. However, it is recommended still to seek professionals when computing for your rental depreciation.