Overview of Rental Depreciation

December 18, 2024 9 min read

An Investor's Guide To Rental Depreciation

In this article, we'll explore rental depreciation. In the world of real estate investing, it’s crucial to have an understanding of rental depreciation and how it works, as it impacts your bottom line and can save you thousands of dollars in taxes. Below, we’ll walk you through what depreciation is, how it works, relevant tax details, and the importance of accurately tracking it.

What is Rental Depreciation?

Generally speaking, depreciation is the gradual decline of the value of property over its useful life. Many types of property depreciate—cars, electronics, appliances—and real property. Both commercial and residential property decline in value over time, and this depreciation is expected. It’s a way to account for inevitable wear and tear, deterioration, or obsolescence of the property and its associated assets.

The IRS allows deductions for depreciation because it recognizes that your rental property experiences wear and tear over the years, therefore reducing its value. To account for this decline, the IRS permits you to deduct a specific amount from your taxable income each year. This deduction effectively compensates for the property’s loss in value by lowering your overall tax liability. The amount you can subtract (or deduct) is determined by the type of property and its cost basis, also known as the initial value. These deductions are spread out gradually over the property’s lifespan.

For residential rental properties to qualify for depreciation, they must meet certain criteria. First, the investment property must be used for a long-term rental business, as this means it should be rented out or available to rent for at least one year. Additionally, the property must be subject to gradual wear and tear, which excludes vacant land because land does not depreciate. The property owner must also have ownership for at least one full year and must use the property in a rental business capacity, not as a personal residence.

How Depreciation Works in Real Estate

When you purchase a rental property, the IRS doesn’t permit you to deduct the entire cost in the year of purchase. Instead, you spread the depreciation deductions out over the property’s useful life, as determined by the IRS. For instance, depreciation for a residential property must be spread over 27.5 years, while commercial properties must be depreciated over 39 years.

According to Investopedia, it’s typical for a US residential property to depreciate at a rate of 3.636% every year for a period of 27.5 years. The IRS allows (and requires) you to deduct a set amount from your taxable income each year that the property is owned and rented. This process begins when the property is available and ready to be rented.

However, when you eventually sell a depreciated property, you will still be subject to taxes on the sale, which is known as depreciation recapture. The depreciation recapture rental property requirement will impact your overall tax liability.

Recovery Periods for Various Asset Classes

An asset’s recovery period is the length of time over which you must depreciate it. The IRS assigns specific recovery periods for various assert classes. The standard recovery periods that are reported in IRS Publication 946 are listed below:

Residential Rental Property: 27.5 years

Commercial Property: 39 years

Land Improvements: 15 years

Computers and Office Equipment: 5-7 years

Appliances and Furniture: 5-7 years

Each of these periods represents the expected useful life of the property and the length of time over which you must depreciate the asset. Depreciation has the advantage of allowing you to defer the payment of tax on your rental income from the years in which it was generated to the year you sell the property. This tax deferral provides a short-term financial benefit, giving you more money upfront that can be reinvested. The funds you have now are more valuable and can be used to generate additional returns, which is a significant advantage for landlords. However, down the line, depreciation recapture will still need to be addressed once the property is sold.

Relevant Tax Information

When Does Depreciation Start and End?

The depreciation of rental property begins when your rental property is ready and available for rent, even if you haven’t had the opportunity to find tenants yet. For example, if your property is fully prepared and listed for rent in June, you can begin depreciating it that month, regardless of when or if it’s officially occupied. This distinction is crucial for maximizing your tax benefits. Depreciation continues until you have fully depreciated the property or if you stop using it for rental purposes (e.g., you sell it or convert it to personal use).

How is Depreciation Calculated?

The IRS mandates the use of the Modified Accelerated Cost Recovery System (MACRS) for depreciating rental properties. Under MACRS, property owners generally have two depreciation methods to choose from: the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). GDS is the more commonly used system for most rental properties, while ADS is required in only certain situations, such as for tax-exempt use property or when opting for longer recovery periods.

For most residential rental properties, GDS uses the straight-line method over a 27.5-year recovery period. This method evenly spreads the depreciation amount over the property’s useful life, providing a steady annual deduction. For commercial property, GDS applies a 39-year recovery period.

ADS is used when mandated by the IRS or when a taxpayer chooses to use it. ADS results in a slower depreciation schedule, as it extends the recovery period. For example, a residential property under ADS has a 30-year recovery period.

To calculate rental property depreciation, you must determine the cost basis of your property, which is the total value of the property minus the value of the land. Using the straight-line method under MACRS, you divide this depreciable basis by the recovery period, resulting in a consistent annual deduction amount. This uniform deduction provides a predictable way to offset rental income, which helps simplify tax planning and makes it more straightforward.

It’s important to understand the tax details associated with rental depreciation to ensure that you accurately track when your property becomes available for rent. This understanding maximizes your depreciation benefits and staying compliant with IRS regulations.

Reporting Depreciation

Reporting depreciation accurately on your tax return is essential to take full advantage of the tax benefits that are associated with rental properties. The primary form used for this purpose is IRS Form 4562, which covers both depreciation and amortization. To report depreciation, you will generally follow these steps:

Calculate the Depreciable Cost: Real property’s depreciable basis is determined by subtracting the value of the land from the total purchase price of the property. It’s vital to separate the cost of the land and the building because land is explicitly defined as non-depreciable and never loses its value to depreciation. You may need to use the property’s tax assessment records or hire an appraiser to get an accurate valuation of the land and building components. For example, if you purchased a building for $300,000 and the land is valued at $60,000, your depreciable basis for the building would be $240,000.
Determine the Recovery Period: The recovery period of an asset is determined by its asset class. For example, a residential rental property has a recovery period of 27.5 years, and a nonresidential or commercial property has a recovery period of 39 years. Other asset classes, such as office furniture or equipment, have shorter recovery periods ranging from 5 to 15 years according to the IRS. These periods are dictated by the expected useful life of the property or asset.
Apply the Depreciation Method: Using the straight-line method for residential real estate, you will spread the depreciation expense evenly throughout the recovery period.
Complete IRS Form 4562: When filling out Form 4562, you will need to list each property or asset you are depreciating, along with details such as the date the asset was placed in service, its depreciable basis, and the recovery period. This form also includes multiple sections for each type of asset, so it’s important to correctly categorize each one. Once completed, you must attach it to your annual tax return (Form 1040 or 1040-SR) to claim the depreciation deduction.

To find more details on filling out Form 4562, visit the official IRS website or seek professional tax advice.

Maximizing Tax Savings Through Depreciation

Keeping detailed and accurate records of depreciation is crucial for both short-term and long-term financial health. Here’s why:

Tax Savings: Depreciation is a powerful tax-saving tool. By reducing your taxable rental income, you effectively lower the amount of tax owed each year. For example, if you have $20,000 in rental income and $8,000 in depreciation expenses, you’ll only be taxed on $12,000 total. These savings can add up immensely as the years pass, improving your property’s eventual return on investment.

Financial Planning: Tracking depreciation helps you evaluate your property’s true value and performance. As your property ages, depreciation can impact your financial projections and investment strategies. Proper tracking allows you to plan for future expenses such as renovations and asset replacements, and it also allows you to make informed decisions about buying or selling properties.

Compliance and Audit Protection: The IRS requires meticulous documentation of depreciation expenses, including your methods of how you calculate depreciation on rental property and for deductions. If you happen to be audited, having well-organized records can help protect you from potential penalties or adjustments. This includes keeping receipts, property records, appraisals, and copies of tax returns dating back several years. This can often be handled by a tax accountant or can be simplified with accounting software.

Maximizing Deductions: To ensure you’re taking full advantage of the available depreciation deductions, consider using accounting software that offers financial tools like a real estate depreciation spreadsheet or schedule. These tools can help automate calculate depreciation on rental property, track the annual depreciation schedule, and simplify the process of updating records as the years pass by. Automating depreciation tracking can also reduce the risk of errors, ensuring you never miss out on eligible deductions.

Maximizing Your Investment Through Rental Depreciation

Understanding rental property depreciation is essential for real estate investors or rental property owners looking to optimize their returns. By spreading out depreciation deductions for your rental property over its useful life, you can lower your taxable income and save significantly when you file your taxes. Accurate tracking, strategic planning, and compliance with the IRS rules are vital to reaping the benefits of depreciation. In the long run, a confident grasp on understanding depreciation on a rental property will help enhance your investment strategies and improve your bottom line.