It is a known fact that investing in real estate comes with significant tax advantages. Many investors avail themselves a majority of tax benefits to minimize losses or maximize profits. Interestingly, many investors miss out on reducing their taxable income simply because they are unaware of the depreciation rules used on real estate assets.
When used wisely, the depreciation rules can even eliminate income taxes, in some cases. This blog is an overview of how rental property depreciation works, why it is such a big benefit to investors.
What is Depreciation?
In simple terms, depreciation is the asset’s value, which is written off over the useful life of the asset deducted over a long period. There are two ways of removing the cost of investments –
- deducting smaller and non-durable items, which are generally written off all at once, such as repairs.
- writing off the asset’s cost over the useful life of 1 year or more, directed throughout the asset’s life period. The second type of writing off is a capital expense and is known as depreciation.
For an asset or property to depreciate – it needs to have a useful quantitative life. Here’s a simple example of how depreciation works to understand it better. Let’s say the value of an asset is $20,000. This asset is expected to last for 20 years.
Thus, in this case, the business can deduct $10,000 of this cost every year for ten years until the asset’s value is completely written off. In essence, depreciation allows the business’s capital expenditure to lower a business’s taxable income for the asset’s life period. Such capital expenditures can be beneficial for rental real estate businesses.
The number of useful life years of an asset is prescribed according to different legislations and some assets, including commercial rental properties, have IRS determined valid life years.
Rental Property Depreciation
When you buy a property to rent, you can depreciate the rental property cost over some time. As there are no hard and fast rules on determining the useful life of rental properties, the IRS provides guidelines concerning depreciation of real estate.
According to the IRS, you can take residential rental real estate properties to have a useful life of 27.5 years.
To put it simply, it means that you can write off the depreciation expense equally throughout 27.5 years. On the other hand, if you want to charge depreciation for commercial real estate properties, the depreciation period prescribed by the IRS is 39 years.
An interesting thing to note here is that only the value of the property can be depreciated but not the land that is built. The simple logic behind this is that buildings have a useful life span, whereas lands do not. Lands do not get “worn and torn” and do not depreciate.
Till when can you Depreciate the Value of a Rental Property?
As an investor, you might be interested in knowing the period until you can depreciate your residential or commercial rental property value. As per IRS, you are allowed to decline a rental property over its life period until you sell the property or when you have depreciated your property value entirely.
What is the cost basis of rental properties?
To calculate the amount of depreciation, it is important to calculate your rental property’s cost basis. The cost basis of rental property is essentially the acquisition cost, which includes any mortgage that you might have taken, less the value of the land it is built on.
You are only considering the costs of building and loan cost but excluding the land’s appraised value. Here is some other cost which is included while calculating the cost basis of rental properties:
- The legal costs associated with acquiring property.
- Taxes about the transfer of property.
- Title insurance costs.
- Property survey costs.
- Any death cause of the seller that you may assume.
Although in most cases, the cost determined by using the above method is considered the cost of the property throughout the life period of the property. In some cases, your cost basis can be “adjusted” over time. This is called an adjusted cost basis.
It includes the cost of additions and improvements that you make to the property, expenses related to casualties or damages, and the cost of running the property’s utilities.
What are the criteria that need to be met to depreciate your rental property?
To depreciate your rental property, here are a few criteria that you need to meet:
- You must be the owner of the property. In other words, you cannot rent the property and then sublet it to someone else and claim a depreciation deduction.
- Should use the rental property against which you are charging depreciation to generate income. In a typical real estate case, you should rent to tenants and earn rental income.
- The rental property must have a useful life exceeding one year. While this might not be an issue with rental real estate and other capital expenditure types, there is a guideline on what property can be depreciated and what kind of expenses can be expensed off immediately.
- There should be a procedure to determine the useful life of the property. In some cases, you can use IRS guidelines when it becomes challenging to decide on the property’s useful life. For example, as we discussed, residential real estate can be written off over 27.5 years, while you can write off commercial real estate for a useful life of 39 years.
These are the four main criteria you need to satisfy to charge depreciation against the property value. Besides, other conditions include holding your property for more than a year.
This means that when you plan to buy a house, make some repairs and flip it for profits – you generally cannot charge depreciation for this property during your holding period.
Thus, most of the fix-and-flip investors cannot claim the benefits of rental depreciation. Over and above these rules, when you are still unsure about how to go about charging depreciation for rental property, you should consult a qualified tax professional.
Demonstration of how depreciation can be a big tax advantage for real estate investors
Let’s say you have a commercial rental property that makes $6000 in annual income after deducting all expenses. Additionally, if you charge a depreciation expense of $4,000 per annum, this will reduce your property’s taxable income to only $2,000.
This is how many commercial real estate investors save up on their taxes by charging depreciation. For this purpose, many rental properties show a loss for tax purposes, although it might be quite profitable in reality.
Thus, it is always beneficial to understand how rental depreciation works and implement the same to your properties, which can save you many costs. Consult a certified tax professional in case of confusion as tax savings can be a huge pay-off in terms of depreciation.