Rental Property Depreciation Explained
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?
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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 experiences 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.
"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.
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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 because the 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.
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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.
Typically, rental property depreciates at a rate of about 3.6% for 27.5 years for residential properties, according to the IRS.
Determining the property value may not seem complex, but estimating the land value can be challenging, experts say.
Since land is not depreciable, investors are required to separate the property value from the value of the land.
"People glaze over this and that's a mistake because it can cause problems with legality," Lavdas says. "Say you bought a property for $1 million. It's reasonable to estimate the value is about 10% in land, but since that's not always the case, you need to get a third-party document (such as a tax appraisal) to back up that figure."
Kokalari-Angelakis says you must determine the total cost value of the property, including the buying and closing costs and any home improvements, when calculating depreciation. Moreover, the value of the land needs to be determined and deducted.
"Don't start depreciation until the property is ready to be rented out," Kokalari-Angelakis emphasizes.
After the fundamental components are determined, finding the depreciation amount is a simple calculation.
Depreciation equals buying costs plus closing costs and adding home improvements before subtracting the land value and then dividing it by the depreciable lifespan.
The property value divided by the number of years of depreciable lifespan results in the tax expense amount that can be written off on an annual basis.
For example, a real estate investor who purchases a residential property valued at $150,000 determines the depreciation amount by dividing $150,000 by 27.5, which comes to nearly $5,455, the deductible amount from annual taxes.
Depreciation has to be filed within a year, otherwise you will miss the opportunity for tax benefits. You either "use it or lose it."
In recent years, Lavdas says tax laws have allowed owners to take significant additional deductions by looking more closely at different parts of the property that depreciate.
"You do that by having a cost segregation analysis done by a professional. It costs money, but it can pay off if you're strategic about it," she says.
An important part of the process can include a cost segregation study. In this analysis, a consultant reviews the rental property to determine if certain parts of it can be classified as personal property to separate it from the real property.
Then, the personal assets will be listed in shorter depreciation periods for increased depreciation benefits apart from the real property and can accelerate the depreciation advantage.
"Realtor Brandon Brittingham, who owns our firm, did a cost segregation analysis on a $7 million property. (The analysis was $6,000) but it resulted in $1 million in depreciation deductions for the current year," Lavdas says.
How to Report Depreciation to the IRS
To depreciate a property, the owner has to report rental income, expenses and losses to the IRS.
There are different IRS forms to fill out to list your total income, expenses and depreciation for each rental property.
If you have more than one rental property, you must enter the depreciation you are claiming for each property, as required by the IRS.
Reporting all these details can feel overwhelming for new real estate investors, as there are certain qualifications under investment rules that need to be determined. Some investors don't know how to apply all the rules, making real estate investing more complicated, Gonzalez says.
If you're a new real estate investor, getting a good accountant or certified public accountant (CPA) firm can help you navigate the maze of rules.
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