Rental Property Depreciation Explained
Rental properties aren’t just about collecting rent. There are other significant benefits, too.
Rental property depreciation can bring tax benefits to an investor and their real estate business. (GETTY IMAGES)
THERE ARE DISTINCT advantages real estate investments deliver that other investments just can’t offer.
These include rental income, which acts like dividend income, along with substantial tax advantages and expense write-offs, which can feel like bonuses.
“Owning a rental property isn’t just about collecting rent or making money long-term off a property sale,” says Sara Lavdas, CFO at The Maryland and Delaware Group of Long and Foster Real Estate in Salisbury, Maryland.
Real estate investors who purchase a property to rent out to tenants as an income-producing business can depreciate the cost of maintaining or improving a particular property, which offers compelling tax incentives. Here are a few common rental depreciation questions:
- What is rental property depreciation?
- What are some depreciation tax advantages?
- How to report depreciation?
- How is it calculated?
What Is Rental Property Depreciation?
The Internal Revenue Service defines depreciation as a yearly income tax deduction, allowing the investor to recover the cost of certain properties during their use. This serves as an allowance for the deterioration a property experience that results in business expenses.
Straight-line depreciation is the most common form of depreciation, in which the value of the rental property is evenly reduced each year over the useful life of the asset.
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“In the tax world, it’s assumed that rental properties degrade over time and rental property owners are allowed to take a tax deduction for a certain amount of the property’s value. That’s called depreciation,” Lavdas says.
The process of rental property depreciation involves writing off or subtracting rental property expenses on your annual tax returns. Property depreciation can help the property owner reclaim the costs of the income-producing rental property by way of tax deductions on your income.
Your property can be depreciated if it meets certain requirements as determined by the IRS: You own the property, you use the property in your business or income-producing activity, the property has a determinable useful life and the property is expected to last more than a year.
Depending on the property type, depreciation deductions are spread over 27.5 years for residential properties and up to 39 years for commercial properties, but it can vary. This is important for calculating depreciation. As stated by IRS rules, the method of depreciation most taxpayers use is the Modified Accelerated Cost Recovery System (MACRS). Under the IRS direction, the MACRS table lists asset classes with different depreciation periods, which helps determine the depreciation amount of a property.
One of the requirements of depreciation is having a determinable useful life or definite lifespan, meaning the rental property wears down normally over time.
“Depreciation is an income tax deduction that allows a property owner to recover the cost of acquiring and making a property operational in order to collect income,” says Evi Kokalari-Angelakis, founder and CEO of Golden Key Realty in New York City.
Certain factors are disqualified from depreciation. Kokalari-Angelakis mentions that land value is not included since it does not depreciate.
The cost of land will generally remain consistent since it doesn’t become worn down or out-of-date. Also, if you are a tenant who pays rent, the property in which you reside cannot be depreciated; only the owner of the residence can depreciate their property.
The course of depreciation of a rental property starts when it’s first being used as a means to collect rental income, and the depreciation process comes to an end when the rental service ends or when the property owner has collected for the property’s value and expenses.
Some may confuse depreciation with the reduction of value of an asset; however, depreciation does not characterize the loss of value of a property. Rather, it has to do with taking account for property costs.
What Are Depreciation Tax Advantages?
Rental property depreciation can bring tax benefits to an investor and their real estate business.
A huge incentive for real estate investing is lowering your tax liability to save money on your taxes each year. To qualify for tax advantages, you would have already needed to have spent money on the rental property.
“Any tax deduction can flow through all income tax deductions where losses generated from real estate would offset expenses from the business, bringing down tax liabilities from any type of income,” says Julio Gonzalez, founder and CEO of Engineered Tax Services in West Palm Beach, Florida.
There are two different types of real estate investors: active and passive participants. This distinction is important becausethe IRS is looking at these characteristics to see if participants measure up to requirements to meet certain losses.
Taxpayers qualify as active real estate professionals if they participate in more than 750 hours of service during the tax year in the real estate business.
Passive participants – generally referring to investors involved in passive activity through rental businesses, such as rent collection – only offset passive losses restricted to passive income, where qualifying activity hours are lower.
Components that can be reported as “depreciable” assets are ones that add value to your rental properties and anything associated with managing it.
Home improvements that add value to the property or your laptop that’s used to track data on your rental business are all acceptable, experts say.
The cost of renovations becomes part of the basis for depreciation along with some of the closing costs, Kokalari-Angelakis says.
These deductibles are required to have a shelf life of one year at a minimum and steadily lose their value over time.
How to Calculate Depreciation
The amount of depreciation is determined by several components, including the estimated value of the land as well as the building or residential property’s value.