Real estate can be an incredible long-term investment. If you own rental property, you can also take advantage of a tax benefit called depreciation.
Depreciation can save you a bit on your annual tax return. But there are some rules to understand to get the most out of it and avoid unpleasant surprises when you sell your property.
What is depreciation, and how does it work?
Understanding Real Estate Depreciation
Depreciation rules are part of the tax code, and they allow you to reduce your taxable income by the cost of your property over time. Before we go further, let’s clarify what will depreciate over time versus what you can expense immediately.
- The IRS allows you to deduct some rental property expenses from your income at the onset. For example, if you repair a window or mow the grass. These types of costs are NOT depreciated but deducted in their entirety for the tax year they occur.
- Other costs are capitalized, which means added to the price of the property, and deducted over the "useful life of the property." It’s at this stage where depreciation comes into play. Common examples are the property's purchase cost, plus any improvements to the property, like adding a room or building a privacy fence.
You can only deduct the price attributable to the building—not the land.
How will you know the difference? Check out your closing documents or appraisal for the cost allocation.
Say you purchased a house for $500,000, but the land accounted for 10% or $50,000 of the purchase price. In this case, you could only count $450,000 toward depreciation.
So when does depreciation “start”?
You can begin taking the deduction as soon as the property is "ready" for rental—the roof is fixed, the door locks and everything is in tip-top shape. You don't necessarily have to wait to start taking a deduction until you find a tenant!
You can continue deducting until you no longer use the property or you've deducted the entire cost basis of the rental.
Does Your Rental Qualify?
Here's the thing: not every home qualifies for deprecation. The IRS rules are super-specific, and you have to meet all of them to apply.
- You own the property. But you don’t have to own it outright, meaning, the bank may have a lien on it because you still have a loan. It just has to be your property, not a building that you are renting, and not one a friend or family member is letting you use.
- It's a business or investment. You can’t deduct your own home/primary residence where you currently live.
- The property has a “useful life.” All a “useful life” means is that it can decay. In theory, depreciation is tied to the expected life of the property.
- You expect it to last more than a year. If the property has a useful life of less than a year, depreciation won’t work (or even be necessary).
Remember land costs, which usually include landscaping, don't count as depreciable expenses.
Tips To Calculate Depreciation
You can calculate depreciation in several ways. Fortunately, you don’t need to know them all.
The overwhelming majority of rental property is depreciated using the MACRS system, which calculates depreciation over 27.5 years. Very simply, that means your property is deducted over 27.5 years.
For example, consider you have a property with a depreciable value of $500,000. Divide that by 27.5 to get $18,181.82 per year.
The MACRS system has a general and alternative method, but you will likely use the general. You can see the details on page 9 of IRS Publication 527.
Here are some helpful tips for calculating and tracking your depreciation accurately:
- Know the cost basis of the property. Your cost basis is basically what you paid for the property but is rarely the purchase price. Don’t forget to include any costs for the transaction itself—closing costs, legal fees, titling, etc.
- Separate the property value from the land value. Forgetting this step can be a costly mistake. You may depreciate your land for years before you or the IRS realizes it.
- Watch out for adjustments. If you improve your property, don’t forget to capitalize them. You need to be very careful to understand whether an item should be depreciated or expensed.
Selling Your Property
If you eventually sell property that you have depreciated, the IRS will recapture that depreciation for tax purposes. In other words, depreciation becomes a tax deferral mechanism if you sell the property.
That’s because depreciation lowers the cost basis of your property, so you will have a more considerable gain when you sell. This rule can be a nasty surprise for someone who isn’t expecting it. It’s always important to consider both the short-term and long-term consequences of any financial decision you make.
When you contribute to your 401k at work and lower your current year's taxable income, you can’t lose sight of the fact that distributions will face ordinary income tax rates during retirement. With depreciation, all else equal, you lower the profit and taxable income while you are holding and operating the rental. In exchange for this benefit, you are lowering your cost basis and thus increasing your recognized gain when you sell the property in the future. A quick example:
Purchase price: $500,000
Annual depreciation: $500k / 27.5 = $18,181.81
After 5 years of ownership and operation, the accounting for the property would be as follows:Purchase price: $500,000
(Less: Accumulated depreciation): $90,909.09 ($18,181.81 x 5)
Net Asset Value: $409,090.91
If you sold the property after 5 years for $500,000, you might think it’s a break-even and no taxes should be due, but in reality, you would have a taxable gain in the amount of depreciation taken or $90,909.09.
One piece of good news here is depreciation recapture is taxed at a flat 25% rate. If you are in a higher marginal tax bracket, you would have avoided tax at your marginal rate (as high as 37%) by taking depreciation and then you pay at 25% when you sell and recapture the depreciation. Again, I think this is similar to a 401k strategy where you reduce your income by contributing while you have a high income and then recognize taxes during retirement at a rate that is expected to be lower.
Depreciation can come with significant tax planning considerations. Since we specialize in tax planning, we’d love to help you work through these scenarios so you can be prepared and proactive.
Work With A Financial and Tax Expert
Calculating and managing property depreciation is complex. Unless you are deeply familiar with the rules and are confident in the process, it’s often prudent to get help from a tax expert.
If a rental property fits into your financial plan, be sure you follow the rules to get the most benefit possible.
We would love to help! Call us today to get those property depreciation and tax planning questions answered.