introduction: rental property depreciation
Rental property depreciation is an important part of owning (or considering owning) a rental property. The Internal Revenue Service (IRS) allows taxpayers to deduct the cost of depreciation from their rental income each year. This can help reduce the amount of tax you owe on your rental income. In this article, we will teach you everything you need to know about rental property depreciation, including how to calculate it, what types of property qualify, and how to file for it. We will also provide examples so that you can see how it works in practice.
Rental properties provide investors with the possibility to obtain passive income. However, like any house, there are going to be parts that break down and require care over time. To help compensate for this expenditure, one of the things you might claim is rental property depreciation.
How Does Depreciation in Real Estate Work?
Rental property depreciation enables real estate investors to obtain tax deductions for their property. This is done by persuading the IRS that the item at issue has a determinable useful life.
Once the usable life period of the property is established, you may use a formula to compute the amount of value lost due to depreciation each year and claim the deduction on your taxes. While this article will guide you through the essentials, any inquiries about your unique circumstances should be handled by a tax adviser.
Investing in a rental property may be a wise financial decision. To begin, a rental property may offer a consistent stream of income as you create equity in the property as it (hopefully) appreciates over time. There are also various tax advantages. Rental expenditures are often deducted from rental revenue, decreasing your total tax bill.
Most rental property expenditures, such as mortgage insurance, property taxes, repair and maintenance expenses, home office expenses, insurance, professional services, and management travel expenses, are tax-deductible in the year they are incurred.
Real Estate Depreciation
Another important tax break, the depreciation allowance, operates a little differently. Depreciation is the process through which the expenses of purchasing and renovating a rental property are deducted. Rather than getting a substantial deduction in the year you purchase the property, depreciation spreads the deduction throughout the property’s useful life.
The Internal Revenue Service (IRS) has extremely strict laws governing depreciation, and it’s critical to understand how the process works if you own rental property.
How to determine cost basis
Your cost base comprises the amount you paid for the property plus any extra costs. Unlike the market value, the cost basis utilized for depreciation purposes does not include the value of the lot or land. That’s because the land isn’t susceptible to wear and tear, at least according to the IRS, so land is not depreciable.
For example, if you paid $150,000 for a rental property in a nearby subdivision and the lot value is $20,000, your initial cost basis is $130,000. On top of that, you wish to add other allowed charges such as closing fees or renovations. Remember, the larger the cost basis is, the better since your non-cash yearly depreciation expenditure will be higher and your taxable income will be lower.
Examples of additional expenses that could be utilized to improve the cost basis on your tax return include:
- Legal fees, such as the expense of an attorney reviewing the purchase contract when you purchased the property,
- Fees for recording or escrow
- The costs of a property survey, a septic check, and an environmental inspection
- Most states and municipalities levy transfer taxes, either as a flat fee or as a percentage of property value. A state-by-state preview based on MidPoint data from 2018.
- The cost of title insurance
- Debts accepted by the buyer from the seller, such as an invoice from a contractor for updating already completed work that is being paid for overtime,
Your rental property’s cost base may also be changed or “marked up” from time to time. For example, if you paid $150,000 for the rental property and had to repair the whole roof five years later at a cost of $30,000, your adjusted cost basis is now $160,000 ($150,000 purchase price minus $20,000 lot value + $30,000 roof replacement).
Common upgrades to a rental property include items that increase the property’s value or utility or restore the property to new or like-new condition.
- Adding an additional structure, such as a garage, or turning an attic into a studio apartment
- Putting up a new HVAC or electrical system
- Putting on wall-to-wall carpeting or another flooring
- Improving access to the residence, such as installing a wheelchair ramp or paving the driveway,
- Complete roof replacement.
Note that regular repairs and maintenance are tax deductions that are generally expensed out against operating income instead of being added to the cost basis of a property. If you had to make $1,000 in roof repairs due to wind damage, your cost basis generally wouldn’t be impacted since the repair isn’t deemed an improvement or addition by the IRS.
How much of the tax liability is reduced by depreciation?
When you submit your yearly tax return, you normally enter your rental income and costs for each rental property on the relevant line of Schedule E. The net gain or loss is subsequently reported on your 1040 tax return. Because depreciation is one of the costs listed on Schedule E, the amount depreciated effectively decreases your tax burden for the year.
If you depreciate $3,599.64 and are at the 22% tax rate, you will save $791.92 in taxes that year ($3,599.64 x 0.22).
How to reduce taxable net income via depreciation
Let’s take a short look at the significant advantage that depreciation expenditure offers real estate investors. Depreciation is a non-cash deduction based on the assumption that a residence wears out or depreciates over a period of 27.5 years.
If our single-family rental earns $18,000 in yearly gross rent and our total operating expenditures (including property management, normal maintenance and repairs, interest expense, and property tax) are 50% of our gross revenue, our annual net income is $9,000. However, because of the depreciation advantage, our taxable income is less than half of that.
- $18,000 total yearly revenue minus $9,000 operational expenditures = $9,000 before depreciation.
- $9,000 less a $4,909 non-cash depreciation charge = $4,091 taxable income.
In this case, even though we still have $9,000 in cash profit, we only have to pay taxes on less than half of the real cash we got. If you’re in the 32% tax bracket, you’ve probably just saved $1,571 in federal taxes due to the depreciation on your single-family rental property.