An In-Depth Look at Rental Property Depreciation

Rental property depreciation is a tax benefit that allows tax deductions for buildings due to structural decline. Every year, rental property owners can deduct the cost of a property's purchase price, as well as certain capital improvements from their tax returns. This depreciation expense can help reduce the taxable income generated by the rental property, thereby lowering the amount of rental income tax owed by the property owner. In this post, we'll take a closer look at what this means and how rental property depreciation works.

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Real Estate Depreciation: What It Is and How It Works

As we previously stated, depreciation is a method used to account for the wear and tear, deterioration, and obsolescence of income-producing properties over time. While property value often appreciates in value over the long term, for tax purposes, the Internal Revenue Service (IRS) assumes that most properties lose value and become less valuable as they age.

Keep in mind not all properties are eligible for the depreciation deduction. In order to qualify, the property must be an income producing property, AND it must have a "determinable useful life. For example, land does not experience wear and tear. Only buildings and improvements on the rental property can be depreciated, not the land.

Reporting Rental Property Depreciation to the IRS

To claim depreciation on your income taxes, you'll need to complete IRS Form 4562, which is used to calculate and report depreciation deductions. You then include the depreciation expense as a deduction on your Schedule E (Supplemental Income and Loss) when filing your annual tax return.

The IRS assigns different depreciation periods (recovery periods) to different types of property. For residential rental properties, the standard recovery period is 27.5 years. For commercial properties, it's typically 39 years. This means that you can deduct a portion of the property's cost each year over the designated recovery period. According to Investopedia, U.S. residential rental property is typically depreciated at a rate of 3.636% each year over the life of the property. 

When can I start taking depreciation?

The IRS website states that rental property owners can start to depreciate rental property as soon as their rental property is "ready and available for rent." An example provided is if you purchase or vacate a home in July and then spend August and September making repairs. You put the house up for rent on October 1, but don't get a tenant in place until December. In this sample, the rental property is considered "placed in service" as of October 1, meaning you can begin to claim depreciation on the house on October 1.

Starting with the Cost Basis

If you're new to rental property depreciation, your first step in claiming it is establishing your cost basis. On its website the IRS states "the basis of a property you buy is usually its cost. The cost is the amount you pay for it in cash, in debt obligation, and in other property, or in services." Essentially, the cost basis serves as the starting point for determining the value of an asset for tax purposes. Over the life of the property, depreciation will impact the cost basis, which in turn impacts the tax consequences when the asset is sold.

How To Calculate Depreciation

The most common method used for calculating depreciation for rental properties is the Modified Accelerated Cost Recovery System (MACRS). Another depreciation method is called straight line depreciation. Under MACRS, you divide the property's cost basis (excluding the land value) by the assigned recovery period to determine the annual depreciation deduction. Since rental property depreciation calculated is confusing, Fit Small Business has an excellent calculator to do some of the math for you.

Calculating the Rental Property Cost Basis

To calculate the cost basis, Realized Financial Services recommends adding all the costs related to the acquisition of the investment property including purchase price, closing costs, title insurance expenses, rental property improvements, and other expenses together.

It is important to note that for depreciation purposes, the cost basis for the investment property itself and the cost basis for land value must be separate.

Why Rental Property Depreciation Matters to Real Estate Investors

If you don't claim depreciation on a rental property, you may be missing out on a valuable tax deduction and potentially paying more in taxes than necessary. Here's what happens if you choose not to claim depreciation:

Higher Tax Liability

Depreciation is a non-cash expense, meaning you don't actually spend money when you claim it on your tax return. However, it reduces your taxable income, which in turn lowers your overall tax liability. If you skip claiming depreciation, your taxable income will be higher, and you may owe more in taxes.

Missed Deductions

By not claiming depreciation, you miss out on a significant deduction that can offset rental income. This deduction can help you reduce your rental property's taxable rental income and potentially generate a tax loss, which can be used to offset other sources of income.

Lower Cash Flow

Depreciation can also have a positive impact to help you generate income. By reducing your taxable income, it can increase the amount of money a real estate investor keeps in their pocket, allowing them to invest in property maintenance, capital improvements, or other investments.

Potential Future Consequences

Even if you don't claim depreciation in a given year, the IRS allows you to "catch up" and claim it in future years by using methods like the Modified Accelerated Cost Recovery System (MACRS). However, if you consistently fail to claim depreciation, it may raise questions during tax audits, and you could face penalties and interest on the unclaimed depreciation.

Rental Property Depreciation FAQs

Here are some frequently asked questions about depreciation.

Rental Property Depreciation FAQs

Q: What happens to depreciation when a rental property is sold?

A: When you eventually sell the rental property, you may be subject to depreciation recapture. This means you'll need to pay taxes on the depreciation deductions you claimed over the years, at a special tax rate of up to 25% (as of my last knowledge update in September 2021).

 

Q: What are some other tax deductions for investment properties?

A: There are many rental expenses that are tax deductible, including marketing and advertising costs, mortgage insurance premiums, legal fees, property management fees, and more. See our guide to Tax Deductions for Landlords for more information.

 

Q: What is the difference between depreciation on residential properties compared to commercial properties?

A: Both residential property and commercial buildings have an annual depreciation expense, a cost basis, and useful life. The key difference is how much depreciation you can take. 

 

Q: If I deplete my cost basis with depreciation, won't I have to pay capital gains taxes on the proceeds of a future sale of the property (1031 exchanges)? 

A: When you depreciate a property for tax purposes, you are essentially taking a deduction for the wear and tear of the property over time. This reduces your cost basis in the property. However, when you sell the property, the IRS considers the amount of depreciation you claimed as taxable income, and you may have to pay taxes on that depreciation recapture.

In a 1031 exchange, you can defer paying capital gains taxes on the sale of a property by reinvesting the proceeds into a similar, like-kind property. However, the amount of depreciation you claimed on the original property will still be considered taxable income, and you may have to pay taxes on it if you don't continue to defer the gain through subsequent 1031 exchanges.

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The Bottom Line: Rental Property Depreciation Can Be a Significant Tax Deduction

It's essential to keep accurate records of your property's cost, improvements, and depreciation deductions to ensure compliance with tax regulations and maximize your tax benefits. Additionally, tax laws and regulations can change, so it's advisable to consult with a tax advisor or accountant who specializes in real estate taxation to ensure you're taking full advantage of rental property depreciation and staying compliant with current tax laws.