Imagine you just bought your first rental property (congratulations, by the way), and you’re excited about the steady income it will bring. But then tax season hits, and you’re overwhelmed by the costs. Here’s the good news: real estate depreciation can turn that around by lowering your tax liability.
Depreciation lets you deduct the gradual wear and tear of your property over its useful life, helping you to keep more money in your pocket. Understanding how depreciation works—and how to track it on your balance sheet and income statement—can make a huge difference in your real estate bookkeeping.
Depreciation is a tax tool in bookkeeping that can greatly benefit your bottom line. Let’s examine it in more detail, learn about its impact, and how to save more by increasing your deductibles.
What is Real Estate Depreciation?
Depreciation in real estate can seem confusing, especially when buying an investment property meant to appreciate over time. Here’s how depreciation in real estate works and what it means for your tax returns:
Breaking Down Depreciation for Real Estate Owners
Depreciation in real estate refers to the slow and steady loss of value of assets on a property over time.
From a tax point of view, only certain parts of a property are eligible for depreciation on a tax return. The land itself? That is not applicable. However, the structure is prone to depreciation, as are improvements and specific equipment used on the property.
But why get excited about parts of your property depreciating? In tax terms, depreciation is a non-cash deduction that reduces your taxable income, ultimately helping your bottom line.
Depreciation and Asset Life
Depreciation isn’t a random figure that you thumb-suck. Instead, it’s based on what the IRS calls the “useful life” of your property. It is calculated from when the property is put “in service” until it is sold or retired from business purposes, about 27.5 years for residential and 39 for commercial properties.
You can depreciate the rental property a little each year while it is in service. The most common method is straight-line depreciation, but another method, the Modified Accelerated Cost Recovery System (MACRS), allows for higher deductions upfront.
How Does Depreciation Impact Real Estate Bookkeeping?
So, how does depreciation affect your bookkeeping?
Depreciation and Your Bottom Line
Depreciation plays a quiet but influential role in your profit and loss statement. It’s a non-cash expense, meaning you don’t spend anything, but it still reduces your taxable income.
So, even though your rental property may technically be losing value, your cash flow isn’t affected. This is one of the perks of real estate depreciation—you get to keep your rental income while lowering your tax liability.
Tracking Depreciation on Your Financial Statements
To keep things running smoothly, you must maintain accurate bookkeeping when tracking depreciation. To this end, you should reflect depreciation on your balance sheet and income statement. This means keeping detailed records of each year’s depreciation to prepare you for tax season.
Many investors use bookkeeping software like Xero or QuickBooks, which have built-in features for tracking asset depreciation. This automated depreciation calculation feature saves time and ensures accuracy—a useful feature when juggling multiple properties.
Can You Maximize Tax Deductions Through Depreciation?
Yes! Depreciation isn’t just a number on paper—it’s a real tool to lower your tax liability. Here’s why:
Understanding the Tax Benefits of Depreciation
As a real estate investor, you can use depreciation to offset your rental income. This means you can use it to lower your taxable income and keep more money in your pocket to improve the property. It’s like an annual gift from the IRS to investors for owning and maintaining a rental property.
Bonus Depreciation and Section 179 Deductions
Bonus depreciation is another mighty tax-saving tool that allows you to write off up to 60% of eligible costs upfront. Instead of waiting 27.5 years to fully depreciate a property improvement or purchase, you can claim a huge chunk in the first year.
The IRS will be phasing out bonus depreciation. Here’s how it will phase out, according to the US Bank:
- 2023 – 80%
- 2024 – 60%
- 2025 – 40%
- 2026 – 20%
- 2027 – 0%
On the other hand, Section 179 deductions allow you to deduct qualifying business assets—like new HVAC systems or security systems—right away, but within certain limits. The main difference? Section 179 is capped, while bonus depreciation is not.
So, to maximize tax deductions upfront, consider combining these two for serious savings and improved cash flow.
What are Common Depreciation Methods Used in Real Estate?
There are two main methods to calculate depreciation: Straight-line and MACRS.
Straight-Line Depreciation
The straight-line method is the most straightforward way to depreciate your property. Here’s a summary of how it works:
- Ascertain the value of your building (not the land).
- Divide that value by the IRS-defined useful life: 27.5 years for residential properties.
- Deduct the same amount every year. The depreciation amount should equate to 3.636%.
The downside of straight-line depreciation is that you get smaller deductions upfront, which isn’t always ideal if you want to boost cash flow in the early years of owning the property. Still, many real estate investors find this method reliable and predictable, simplifying bookkeeping.
Accelerated Depreciation
If you prefer a bigger tax break upfront, accelerated depreciation methods are your go-to method. MACRS allows you to front-load your deductions, meaning you can claim higher deductions in the early years of your property ownership when your expenses tend to be higher.
Remember, you must still be cautious. Those larger deductions taper off over time, so the long-term benefits aren’t as consistent as those of the straight-line method. However, studies show accelerated depreciation is the preferred route for higher-risk investors.
3 Practical Tips for Accurate Depreciation Bookkeeping
Here are three depreciation-related tips to ensure accuracy in your bookkeeping:
Create a Depreciation Scale
A clear depreciation scale is helpful if you must manage multiple properties. It helps you track which assets are being depreciated and how much you deduct annually. The first step is to categorize everything—buildings, equipment, and land improvements all have different depreciation schedules.
This type of cost segregation allows you to depreciate some assets (like equipment) faster than the building itself.
Use Bookkeeping Software
Tracking depreciation manually can be taxing for bookkeepers with multiple properties on their books. Real estate bookkeeping software can ensure efficiency and accuracy by automating depreciation calculations and updates.
Forbes Advisor rates Buildium as the best bookkeeping software for real estate, giving them a rating of 4.7/5 stars.
Keep Up with Law Changes
Tax laws are always changing, and depreciation rules are no exception. Working with a real estate tax professional to help you navigate the complexities of depreciation and take advantage of all available deductions is a smart idea.
Conclusion
Depreciation is a tax tool integral to maximizing real estate profits. Understanding how it works can lower your tax liability and keep your cash flow intact. Remember to keep accurate records, use bookkeeping software, and stay updated on tax laws to avoid missing out on savings.