Tips and Tricks for Reporting Depreciation on Rental Property

January 6, 2025 6 min read

Reporting Depreciation on Rental Property

When managing real estate investments, depreciation can be both an opportunity and a challenge. Reporting depreciation accurately can save you money and reduce tax stress, but it requires understanding key concepts and using strategic tools.

In this article, we’ll explore essential tips for reporting depreciation, including improvement ratios and the basics of cost segregation. We’ll also discuss creating an effective depreciation report and the tax implications of depreciation so that you can tackle the upcoming tax season with confidence!

What is Depreciation?

Depreciation allows property owners and real estate investors to recover the cost of regular wear and tear on taxable income-producing properties over time. By deducting depreciation annually, you can offset income and lower your taxable profit. However, depreciation is more than a deduction, it’s a long-term tax strategy. The IRS assumes you’ve claimed all allowable depreciation, even if you didn’t, meaning you’ll pay taxes on the amount later when selling the property.

Tax Implications of Depreciation on Property Sales

When selling a property, depreciation directly affects your adjusted cost basis. The formula for profit when selling a property subtracts the adjusted cost basis from the sales price, and depreciation reduces that basis. This increases your taxable profit, specifically, a portion taxed as depreciation recapture.

Depreciation recapture, capped at 25% according to Investopedia, is the IRS’s method of recovering the deductions you claimed or could have claimed. While this might feel like you’re losing money, remember that depreciation provides significant upfront tax savings, making it a worthwhile strategy. It’s important to always claim your depreciation, even if you don’t think you’ll benefit. Skipping it doesn’t save you on your taxes but can cost you in the long run when you sell your property.

3 Tips for Maximizing Depreciation

Now that you know the basics of depreciation, here are our top three tips for maximizing depreciation on this year’s taxes.

#1 Use Improvement Ratios

Improvement ratios are a useful tool for accurately calculating depreciation. Since land isn’t depreciable, you need to separate the value of a building (and its improvements) from the land it sits on. Improvement ratios give you a percentage to allocate to the depreciable portion of the property, helping you get a more precise estimate of the relative contribution of improvements to the overall property value.

To calculate the improvement ratio, you’ll use one of these sources:

Property Tax Bills: These often list separate valuations for land and improvements.
Replacement Costs: Determine the current cost to rebuild the structure, accounting for age and wear.
Buyer-Seller Agreements: If the purchase included separate land and building values, use these figures.
Comparable Land Sales: Estimate the land value using sales of unimproved lots and subtract it from the property’s total price.

For instance, if your property cost you $500,000 and the improvement ratio is 80%, calculating the depreciable basis would look like this:

Depreciable Basis = Total Cost of Property x Improvement Ratio

Depreciable Basis = 500,000 x 0.80 = 400,000

The higher the improvement ratio, the more depreciation you can deduct.

#2 Use Cost Segregation

What is cost segregation?

Cost segregation is a tax strategy that allows property owners to break down their assets into components with shorter depreciation schedules. By identifying short-lived assets (e.g., fixtures, appliances, or landscaping), you can accelerate depreciation and take deductions sooner.

When a property is purchased, it’s common to depreciate the entire building over the standard schedule (27.5 years for residential properties or 39 years for commercial properties). However, through a cost segregation analysis, you can reclassify portions of the property into shorter recovery periods.

For instance, a swimming pool classified as a land improvement can be depreciated over 15 years instead of 27.5, while equipment might have a five- or seven-year schedule. The Tax Cuts and Jobs Act (TCJA) allows bonus depreciation for many of these assets with shorter recovery periods, sometimes enabling you to deduct 100% of these assets in the first year. Keep in mind, however, that bonus depreciation (along with other TCJA provisions) is sunsetting and will fully expire in 2027.

While the benefits of cost segregation are significant (for tax benefits), it’s best suited for those planning to hold the property for at least five years to avoid negating savings through recapture.

#3 Create an Accurate Depreciation Report

An accurate depreciation report is important for claiming deductions and avoiding tax penalties. This report will outline and record all depreciating assets, their values, and schedules. It also provides clarity and precision in tracking assets over their useful life. Not only does it support tax filings, but it also equips you with detailed records for audits, sales, and strategic planning.

Several tools can help you during the process of compiling and maintaining a depreciation report. Two key ones are listed below:

Tax Preparation Software: Programs like TurboTax and TaxSlayer are designed to simplify the process of completing IRS Form 4562, which is required for reporting depreciation. They guide users through complex calculations, ensuring compliance with IRS rules.
Accounting Software: Software like Ledgre can provide you with easily accessible and user-friendly tools to track expenses. It can even automate entries and reduce the need for manual entries and calculations.

There are several tax strategies and exclusions that can influence how you report and handle depreciation. One example is Like-Kind Exchanges (Section 1031). If you sell a property and purchase a similar one through a like-kind exchange, you can defer taxes, including depreciation recapture. However, these transactions require careful structuring and often involve a Qualified Intermediary (QI) to facilitate the exchange. Missteps in this process can lead to unexpected tax liabilities, so don’t be afraid to contact a tax professional for help.

Likewise, the Home Sale Exclusion may help you exclude up to $250,000 ($500,000 for joint filers) of capital gains from taxation when you sell your primary residence. However, any depreciation deductions taken while the property was used as a rental will still be subject to recapture, even if the sale qualifies for the exclusion.

Simplifying Depreciation Reporting

Accurately reporting depreciation is a vital aspect of managing your property investments. By leveraging tools like improvement ratios, employing strategies such as cost segregation analysis, and maintaining a precise depreciation report, you can maximize tax savings, improve cash flow, and ensure compliance with IRS regulations. Understanding the tax implications of depreciation, such as recapture on property sales, is equally important for long-term planning and profitability. Whether you're calculating depreciation for annual deductions or preparing to sell a property, staying informed and organized is essential.