Real estate 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.
Rental property owners use depreciation to deduct the purchase price and improvement costs from your tax returns.
Depreciation commences as soon as the property is placed in service or available to use as a rental.
By convention, most U.S. residential rental property is depreciated at a rate of .% each year for . years.
Investing in rental property can prove to be a smart financial move. For starters, a rental property can provide a steady source of income while you build equity in the property as it ideally appreciates over time. 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.
Another key tax deduction—namely the allowance for depreciation—works somewhat differently. Depreciation is the process used to deduct the costs of buying and improving a rental property. Rather than taking one large deduction in the year you buy or improve the property, depreciation distributes the deduction across the useful life of the property.
The Internal Revenue Service IRS has very specific rules regarding depreciation, and if you own rental property, it’s important to understand how the process works.
According to the IRS, you can depreciate a rental property if it meets all of these requirements:
You own the property you are considered to be the owner even if the property is subject to a debt.
The property has a determinable useful life, meaning it s something that wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes.
Even if the property meets all of the above requirements, it cannot be depreciated if you placed it in service and disposed of it or no longer use it for business use in the same year.
Note that land isn t considered depreciable since it never gets used up. And in general, you cannot depreciate the costs of clearing, planting, and landscaping, as those activities are considered part of the cost of the land and not the buildings.
You can begin taking depreciation deductions as soon as you place the property in service or when it s ready and available to use as a rental.
Here s an example: You buy a rental property on May . After working on the house for several months, you have it ready to rent on July , so you begin to advertise online and in the local papers. You find a tenant, and the lease begins on Sept. . As the property was placed in service—that is, ready to be leased and occupied—on July , you would start to depreciate the house in July, and not in September when you start to collect rent.
You can continue to depreciate the property until one of the following conditions is met:
You retire the property from service, even if you have not fully recovered its cost or other basis. A property is retired from service when you no longer use it as an income-producing property—or if you sell or exchange it, convert it to personal use, abandon it, or if it s destroyed.
You can continue to claim a depreciation deduction for property that s temporarily idle or not in use. If you make repairs after one tenant moves out, for example, you can continue to depreciate the property while you get it ready for the next.
Three factors determine the amount of depreciation you can deduct each year: your basis in the property, the recovery period, and the depreciation method used.
Any residential rental property placed in service after is depreciated using the Modified Accelerated Cost Recovery System MACRS, an accounting technique that spreads costs and depreciation deductions over . years. This is the amount of time the IRS considers to be the “useful life” of a rental property.
While it’s always recommended that you work with a qualified tax accountant when calculating depreciation, here are the basic steps:
Determine the basis of the property. The basis of the property is its cost or the amount you paid in cash, with a mortgage, or in some other manner to acquire the property. Some settlement fees and closing costs, including legal fees, recording fees, surveys, transfer taxes, title insurance, and any amount the seller owes that you agree to pay such as back taxes, are included in the basis. Some settlement fees and closing costs can’t be included in your basis. These include fire insurance premiums, rent for tenancy of the property before closing, and charges connected to getting or refinancing a loan, including points, mortgage insurance premiums, credit report costs, and appraisal fees.
Separate the cost of land and buildings. As you can only depreciate the cost of the building and not the land, you must determine the value of each to depreciate the correct amount. To determine the value, you can use the fair market value of each at the time you bought the property, or you can base the number on the assessed real estate tax values. Say you bought a house for $,. The most recent real estate tax assessment values the property at $,, of which $, is for the house and $, is for the land. Therefore, you can allocate % $, ÷ $, of the purchase price to the house and % $, ÷ $, of the purchase price to the land.
Determine your basis in the house. Now that you know the basis of the property house plus land and the value of the house, you can determine your basis in the house. Using the above example, your basis in the house—the amount that can be depreciated—would be $, % of $,. Your basis in the land would be $, % of $,.
Determine the adjusted basis, if necessary. You may have to make increases or decreases to your basis for certain events that happen between the time you buy the property and the time you have it ready for rental. Examples of increases to basis include the cost of any additions or improvements that have a useful life of at least one year made before you place the property in service, money spent to restore damaged property, the cost of bringing utility services to the property, and certain legal fees. Decreases to the basis can be from insurance payments you receive as the result of damage or theft, casualty loss not covered by insurance for which you took a deduction, and money you receive to grant an easement.
The next step involves determining which of the two MACRS applies: the General Depreciation System GDS or the Alternative Depreciation System ADS. GDS applies to most properties placed in service, and in general, you must use it unless you make an irrevocable election for ADS or the law requires you to utilize ADS.
ADS is mandated when the property:
In general, you ll use GDS unless you have such a reason to employ ADS. Again, it’s recommended that you consult a qualified tax accountant, who can help you determine the most favorable way to depreciate your rental property.
Once you know which MACRS system applies, you can determine the recovery period for the property. The recovery period using GDS is . years for residential rental property. If you re using ADS, the recovery period for the same type of property is years for property placed in service after Dec. , , or years if placed in service prior to that.
Next, determine the amount that you can depreciate each year. As most residential rental property uses GDS, we’ll focus on that calculation.
For every full year that a property is in service, you would depreciate an equal amount: .% each year as long as you continue to depreciate the property. If the property was in service for less than one year for example, you bought a house in May and began renting it in July, you would depreciate a smaller percentage that year, depending on when it was put in service. According to the IRS Residential Rental Property GDS table, that is:
For example, take a house that has a basis of $, and that was put into service on July .
For every year thereafter, you’ll depreciate at a rate of .%, or $,., as long as the rental is in service for the entire year.
Note that this figure is essentially equivalent to taking the basis and dividing by the . recovery period: $, ÷ . = $,. The small difference stems from the first year of partial service.
If you rent real estate, you typically report your rental income and expenses for each rental property on the appropriate line of Schedule E when you file your annual tax return. The net gain or loss then goes on your form. Depreciation is one of the expenses you’ll include on Schedule E, so the depreciation amount effectively reduces your tax liability for the year.
If you depreciate $,. and you’re in the % tax bracket, for example, you’ll save $. $,. x . in taxes that year.
Depreciation can be a valuable tool if you invest in rental properties, because it allows you to spread out the cost of buying the property over decades, thereby reducing each year’s tax bill. Of course, if you depreciate property and then sell it for more than its depreciated value, you ll owe tax on that gain through the depreciation recapture tax.
Because rental property tax laws are complicated and change periodically, it’s always recommended that you work with a qualified tax accountant when establishing, operating, and selling your rental property business. That way, you can be sure to receive the most favorable tax treatment and avoid any surprises at tax time.