You’re not alone in wondering how depreciation works on your rental property, and it’s time to demystify all your questions! As time passes, your investment property may decrease in market value, or you’ll make improvements, and luckily, you get a tax benefit for these costs. So, how does depreciation work?
If you own and rent out a property, you can deduct its depreciation from your taxable income according to the useful life. This includes acquisition costs, renovations, and assets like appliances. You must rent for at least one year to gain this tax benefit.
Property depreciation within real estate may seem complicated at first glance, but with a basic understanding, you can easily enjoy the tax benefits. We’ll uncover the definition of depreciation, the methods and systems, how to calculate it, and the IRS guidelines.
What Is Depreciation On Rental Property?
So, how does depreciation work on rental property? The property you rent out is an asset that generates income, and the costs of costs of maintenance, improvement, and management are seen as business expenses. The loss of property value also counts as an expense.
The general understanding of depreciation is that it is the loss of your property’s market value, but this loss is only part of a tax benefit with the same name. The IRS notices assets that decline in value and gives you a tax benefit called depreciation.
The depreciation tax benefit also includes the costs of acquiring and improving your rental property and additional rental assets like appliances and furniture. This helps relieve value loss by reducing your taxable income. Note that the land value itself does not count for depreciation.
The calculation for depreciation considers the property’s useful life, as determined by the IRS. The typical deduction for most US residential rental properties is 3.636% of costs each year spread over 27.5 years, but can vary depending on the depreciation method. For commercial property, the useful life is often 39 years.
In short, depreciation is an accounting process used to deduct the costs of an asset over its useful life. The calculation involves acquisition costs and loss of market value, including renovations and rental property assets, divided between the years of useful life.
Depreciation Methods
You should consult your financial or tax professional to clarify the best method for your situation. Tax laws and regulations may impact the method you can use. Therefore, staying compliant with the latest tax codes is essential.
Straight-Line Depreciation
Straight-line depreciation is the simplest and most frequently used for rental properties, especially in residential real estate.
The formula: Annual Depreciation Expense = (Cost of Property – Salvage Value) / Useful Life
Declining Balance Depreciation
Declining balance depreciation can benefit rental property owners looking to increase tax deductions during their early years of ownership.
The formula: Depreciation Expense = (Book Value at the Beginning of the Year × Depreciation Rate)
Double Declining Balance Depreciation
This method provides more substantial tax deductions in the early years of ownership but has a shorter depreciation lifespan. It is mainly used when your property is likely to lose most of its value early on or will become obsolete quickly.
The formula: Depreciation Expense = (Book Value at the Beginning of the Year × (2 / Useful Life))
Component Depreciation
Instead of treating your rental property as a single asset, this method breaks it down into individual parts, each with its own useful life. This method is helpful for rental properties with multiple improvements or assets with different depreciation timelines. The formula will be unique to your situation.
Depreciation Systems
Although you’re only likely to use the General Depreciation System, it helps to demystify all possible options, known as Modified Accelerated Cost Recovery Systems (MACRS).
There are two systems:
1. General Depreciation System (GDS): This is the standard and most common one.
2. Alternative Depreciation System (ADS): ADS is only used when the law requires and usually pertains to tax-exempt use and farmland.
How To Calculate Rental Property Depreciation
The next question is, how much depreciation can you get on rental property[JA1] ? You can find out by calculating, which may differ depending on your MARCS and depreciation method. You’ll most likely need a tax professional to calculate accurately.
You should note that you can start depreciation deductions as soon as the property is available for rent. If you advertise, say, January 15th, and only find a tenant on February 20th, you can refer to January 15th.
The Steps To Calculating Your Rental Property’s Depreciation
With these steps, you’ll be set in the right direction to find an accurate calculation.
Step 1: Identify Depreciable Assets
You need to identify and list all the depreciable assets related to your rental property. This includes the building itself, any improvements you’ve made, fixtures, appliances, furniture, HVAC Systems, etc. Each asset needs to be categorized and recorded separately.
Step 2: Determine the Property’s Basis
The basis is the property’s original cost, including the purchase price, closing costs, legal fees, and the cost of significant improvements. The land value is not included because it does not depreciate.
Step 3: Determine the Useful Life
The IRS typically allocates residential rental property with a useful life of 27.5 years. For commercial rental property, it’s likely 39 years. However, certain assets within the property may have different useful lives. Refer to IRS guidelines or consult with your tax professional.
Step 4: Choose a Depreciation Method
The most commonly used methods are straight-line, declining balance, double declining balance, and component depreciation.
Step 5: Determine The Amount That You Can Depreciate Yearly
For GDS, you should depreciate 3.636% of the costs yearly. If your property was in service for less than a year, you would decline a smaller percentage that year, depending on the month it started. Every year after the property has been in service, you would use 3.636%.
According to the IRS, on a GDS basis, these will be your percentages depending on the month your property started service:
- January: 3.485%
- February: 3.182%
- March: 2.879%
- April: 2.576%
- May: 2.273%
- June: 1.970%
- July: 1.667%
- August: 1.364%
- September: 1.061%
- October: 0.758%
- November: 0.455%
- December: 0.152%
Step 6: Calculate
Use the appropriate depreciation method formula and calculate it according to the applicable depreciation rate.
IRS Guidelines and Compliance
To qualify for the depreciation tax benefit, the IRS states that you should meet the following guidelines:
- You must own the property.
- The asset must be part of a business or income-producing activity.
- You must be able to determine the useful life.
- You must expect to rent for more than one year.
- It may not be excepted property. Excepted property (see Publication 946) includes particular non-physical property, specific term interests, equipment used for capital improvements, and property you put in service and get rid of in the same year.
Conclusion
Now that you understand the basics of depreciation in rental property, you are ready for a much-needed tax benefit! Although you can calculate it on your own, you should seek professional help to file your taxes to ensure no stone is left unturned.