Filing taxes is no landlord’s favorite task. Rental property depreciation is particularly complex aspect of taxes that is often misunderstood by landlords.
However, depreciation is also one of the best ways to save money. These deductions apply to most all capital assets you own for at least one year and use for your rental activities, so there’s virtually no downside to recovering the costs of expensive property.
For this reason, it’s critical that you understand the basics of depreciation and how it works.
Let’s dive into depreciation in more detail and learn how you can take advantage of these crucial deductions for your rental business.
Depreciation: The Basic Idea
Broken down into simple terms, depreciation isn’t as complex as it may seem.
Depreciation is the gradual decline in value of a capital asset over time as it gets worn out or used up.
For instance, say you bought a lawn mower to use on your rentals’ lawns. When you first bought it, it was in pristine condition. However, after several years of using it, the lawn mower now takes longer to start, is less effective, and requires more frequent maintenance.
Depreciation deductions are a way to compensate for this decline in value. As your property wears out, the IRS allows you to deduct a set portion of the lawn mower’s cost from your taxable income. This means you pay overall less taxes to account for the lawn mower’s deterioration.
Depreciation deductions are one of the most valuable tax rental property deductions available for landlords. Why? Because it gives you access to more cash in the short-term, which you can re-invest in your properties.
Depreciation Schedules and Recovery Periods
So how and when do you take depreciation deductions?
Depreciation starts when you place the property “in service.” For buildings, this means the date that your units are ready to rent (not necessarily filled). For other types of property, depreciation starts when you start using it for your rentals.
Depreciation stops when you either 1) retire the property from use, 2) sell it, or 3) fully recover the property’s value.
Each type of property has a set recovery period, or length of time it is depreciated. These periods are determined by the IRS. For example, a residential building is always depreciated for 27.5 years.
There are also different depreciation methods. The most common method is straight-line depreciation, wherein an equal percentage of the property is deducted each year.
Finally, each type of property has a rental property depreciation schedule. A depreciation schedule lists the amount you can deduct for each year of ownership.
Determining the Cost Basis
Before you can depreciate your property, you need to know its cost basis. This is its starting value or the amount of your total investment.
Typically, the cost basis is the amount you initially paid for the property. However, buildings are slightly more complex. When you buy a building, you often pay extra fees tied to the sale, such as title transfer fees. These fees are included in the cost basis.
You may also improve the property over time, such as adding a room or replacing the flooring. The amount you pay for these improvements is also added to the cost basis.
If you’re using the straight-line depreciation method (as you would for real property), your deduction amount will be a fixed percentage of the property’s basis.
To calculate your exact deduction amount, review the depreciation schedule for the property closely. It should tell you the percentage you should depreciate and deduct based on the length of the recovery period.
Personal property (such as furniture, computers, or equipment) can be depreciated using a different method, called accelerated depreciation. This method allows you to deduct larger amounts in the initial years.
The final tax concept you should know is rental property depreciation recapture.
The basic idea of depreciation is the gradual decline in value of property. That decline is assumed for all types of property investment. However, what happens when your property actually appreciates over time, as many do?
Your property appreciates when you make improvements. A smart landlord will do so throughout their ownership. In this case, you seem to be getting a better deal than you should. You’re taking depreciation deductions when your property’s value is really going up.
To account for this problem, the IRS will eventually “recapture” the taxes you avoided paying when you sell. The profits you report that are attributable to the depreciation deductions are taxed at a slightly higher rate than the general capital gains rate.
This makes same-year deductions more profitable than depreciated ones, but depreciation is still beneficial in the long run as it gives you access to capital up front.
Depreciation is a complex topic few landlords can and should tackle on their own. However, by understanding the basics and asking for help when you need it, you can use depreciation to save hundreds of dollars on taxes each year.