Investing in rental property comes with several key benefits, including passive income, net worth growth, and impressive tax advantages. And in this article, we’re going to focus on one of the greatest tax advantages available to income property owners: rental property depreciation.
You might know that you can deduct most property-related expenses from your income taxes each year. But did you know that you can essentially deduct the acquisition cost of your rental property from your income taxes? The process of rental property depreciation allows you to do exactly that!
Here is everything you need to know about how rental property depreciation works.
What Is Rental Property Depreciation?
Rental property depreciation is a tool real estate investors use to reduce their income tax burden. It is based on the idea that a structure wears out over time and that property owners should be able to claim the annual depreciation value on their annual income tax filings.
The Internal Revenue Service (IRS) allows income property owners to deduct a percentage of the purchase price plus improvement costs each year that the property is used for business or income generation. This can continue until the total value of the purchase price and improvements has been claimed.
Which Properties Are Depreciable?
According to the IRS, properties are depreciable as long as the following criteria are met:
- You own the property (you can be the owner for this purpose, even if the deed is currently held by a lender).
- The property is used for business purposes or as an income generator.
- The property has a definable “useful life” (meaning that it naturally wears out over time). For example, the IRS has determined that most residential structures have a useful life of 27.5 years.
- The useful life of the property is more than one year.
It is important to note that depreciation applies only to structures, never to land. Land generally does not wear out or lose value over time. In fact, the ability of land to continuously grow in value is one of the greatest benefits of real estate ownership! But this means you cannot include the costs of maintaining or improving the land (through activities like grading or planting) in your depreciation calculations.
Another important note is that you cannot depreciate a rental that you place in service and remove from service within the same year.
MACRS, GDS, & ADS
Before we can discuss how to calculate depreciation on rental property, we need to explain a few depreciation-related accounting terms.
- Modified Accelerated Cost Recovery System (MACRS): The accounting process of spreading the cost of the property and improvements over the useful life to determine how much to depreciate for tax purposes each year.
- General Depreciation System (GDS): The specific depreciation method used for most residential rental properties. This method uses the IRS’ standard useful life of 27.5 years.
- Alternative Depreciation System (ADS): The specific depreciation method used when the GDS method isn’t appropriate. In general, ADS is used only when the property owner makes an irrevocable election for ADS on the advice of a certified accountant or when special circumstances legally require the use of ADS. ADS is legally required if the property has a tax-exempt use, is financed by tax-exempt bonds, is used in farming, or is used for qualified business purposes less than half the time. This method has a useful life of 30 years.
How to Calculate Depreciation on Rental Property
Here is how to calculate your rental property depreciation using MACRS, step-by-step.
1. Determine the “Cost Basis” of Your Property
The cost basis of your property is the cost you incurred buying the depreciable property and placing it in service. This is the total value that you can deduct from your taxes over the years.
Many investors believe the cost basis is simply your purchase price plus closing costs. But it can be a little more complicated than that.
First, not all closing closed are legally allowed to be included in your cost basis. Closing costs like legal fees, recording fees, transfer taxes, and title insurance can be included in your cost basis, while fees associated with getting a mortgage loan cannot. So to begin finding your cost basis, you’ll want to add only qualified closing costs to your purchase price.
Then, as you’ll recall, only structures can be depreciated. Land cannot. So you need to determine how much of the property value should be allocated to the structure. In most cases, your property tax bill will specify a value for the land, and a value for the structure (confusingly, the structure is likely called “improvements” on your tax bill). However, since the taxable value changes year to year, you don’t want to use the values on your tax bill; you just want to use those values to find the allocation ratio, which you can then apply to your purchase price.
This will make more sense with an example.
Cost Basis Calculation Example
Say you paid $800,000 for your rental property (including qualifying closing costs). And, according to your current tax bill, the taxable value of your property is $875,000, with $200,000 allocated to land and $675,000 allocated to improvements.
If you divide the improvement value by the total value, you can see how much of your property’s value is for the structure. In this case, 675,000 / 875,000 = 77%.
So now, you can apply this 77% to your purchase price to get your cost basis. $800,000 x 77% = $616,000.
$616,000 is your cost basis.
2. Adjust the Cost Basis as Appropriate
If you’ve made improvements to the structure, you can add the cost of those improvements to your cost basis.
On the other hand, if you received an insurance payout because of property damage or accepted money to grant an easement, those values would need to be deducted from your cost basis.
Adjusted Cost Basis Calculation Example
Using the above example, let’s say you renovated to increase the value of your rental property. And you invested $100,000 in the renovation. You could add this amount to your $616,000 cost basis to bring your adjusted cost basis to $716,000.
3. Divide Your Adjusted Cost Basis by the Property’s Useful Life
At this point, you simply need to divide the adjusted cost basis by the number of years in the property’s useful life to determine your annual depreciation amount. But remember, the useful life figure you use will depend on your MACRS method. If you’re using GDS, you’ll divide the adjusted cost basis by 27.5. If you’re using ADS, you’ll divide the adjusted cost basis by 30.
In our example, if we’re using GDS, we would divide $716,000 by 27.5. This means our annual depreciable value would be $26,036.
4. Calculate Your Depreciation Schedule
There’s just one more complication. You only qualify for the portion of the depreciation that you see from the month you put your property in service until the end of the year. So, unless your property happens to go into use on January 1, you don’t qualify for the full annual amount in your first year.
So we need to calculate the depreciation schedule so that we know how much to deduct in the first year. If you’re using GDS, your typical annual deduction will be 3.636% of your adjusted cash basis. Notice, in the example above, $26,036 is 3.636% of $716,000. But instead of using this value for the first year, we will consult the IRS’ Residential Rental Property Table to see what percentage of the total cost basis we should use for the first year.
If, for example, you purchased your property in July, you would use 1.667% of your cost basis for year one according to the table. $716,000 x 1.667% = $11,936. $11,936 is the amount you could deduct from your taxes in the first year of the property's use.
When in Doubt, Consult a Tax Accountant
Rental property depreciation can be complex. We recommend always consulting with a qualified tax accountant when calculating your depreciation schedule.
Rental Property Depreciation Recapture
When rental property owners sell their property for more than they paid, the government requires that the depreciation claimed on prior tax returns be repaid. This is because the higher sales price indicates that the scheduled depreciation was not realized as a loss by the property owner. On the contrary, the property (even the structure with its years of wear and tear) has appreciated. So property owners are responsible for “depreciation recapture,” meaning the repayment of the claimed depreciation.
This depreciation recapture is claimed as normal income on the income tax filing for the year that the property sells.
Additionally, investors should expect to pay capital gains tax on the profit from the sale.
One important note is that real estate investors can defer both depreciation recapture and capital gains tax by using a 1031 exchange. A 1031 exchange is a sophisticated real estate investing tool that rolls the profits from the sale of a property into another real estate investment. Through this practice, the investor doesn’t actually realize any of the profits since they go directly into the new deal; therefore, no taxes are due until that new investment property sells and the gains are realized. Property owners can string together 1031 exchanges to defer the taxes indefinitely.
Rental Property Depreciation Impact on Taxes
Depreciation is one of the greatest tax benefits of real estate investing. When you depreciate the property on your income taxes, your lower your total income tax burden.
Here’s how it works.
As a rental property owner, you must list all rental income and expenses on your annual tax returns. Your calculated depreciation can be one of the expenses that helps offset some of your gains. This effectively lowers your taxable income, reducing the amount of income tax you owe based on your tax bracket.
For example, if you have $26,036 in annual depreciation, and you’re in the 22% tax bracket, you would save $5,728 on your taxes due, thanks to depreciation.
Rental Property Depreciation FAQs
Here are some quick answers to some of the most frequently asked depreciation questions.
When can I start taking depreciation?
You can begin taking depreciation the year your property is placed into service as a business asset or income generator. You will claim the depreciation for the property on the tax return for the year in which the property began being used for this purpose.
How long does depreciation last?
Depreciation lasts until the end of the useful life of the property. If you’re using the GDS depreciation method, your depreciation on a residential rental property will last 27.5 years, and if you’re using the ADS method, your depreciation on a residential rental property will last 30 years. Having said that, if you stop using the property for this purpose before the end of its useful life, the depreciation stops at that point.
Which IRS forms Do I Need to File for Rental Property Depreciation?
IRS Form 4562 is used to calculate and report your depreciation schedule. Then, each year, you will claim the depreciation with your other property-related deductions on Schedule E of your 1040 Form.
Tax Deduction vs Depreciation: How Do I Know Which Applies?
Deductions are used for operating expenses that are required to purchase items that serve day-to-day functionality. Depreciation is used for capital expenses that have a useful life of more than a year and are used for future benefits.
For example, air filters are an ongoing day-to-day expense and can be deducted in the year in which the expense is incurred. Adding central air conditioning, on the other hand, adds value to the real estate. So this is a capital expense with a useful life of more than one year, which can be depreciated over time.
Is There a Depreciation Limit?
There is a depreciation limit for most real estate investors. Owners with adjusted gross income under $100,000 can deduct up to $25,000 in rental real estate losses each year the property is in service. This amount is tapered for higher earners and is not available to those with an adjusted gross income of more than $150,000. These limits do not apply to real estate professionals, who can deduct losses from their non-passive income.
What Happens if I Forget to Claim My Depreciation?
You can always amend your most recent tax return by filing Form 1040X to capture your depreciation if you forgot to claim it on your initial tax return.
Invest in Rental Properties with Gatsby Investment
Rental property investing is exceedingly rewarding. But managing your own rentals can expose you to potential liabilities, particularly when it comes to complicated accounting or market analysis.
This is just one of the reasons why today’s investors are turning to real estate syndication as an attractive alternative to traditional rental property investing. With syndication, you get to take advantage of an entire team of specialized real estate professionals.
Here at Gatsby Investment, for example, we have a dedicated accounting team to make sure our investors are capitalizing on their tax benefits from our projects, including capturing rental property depreciation. This is in addition to our expert real estate analysts, award-winning architects, builders, and designers.
When you’re ready for your next rental property investment, consider Gatsby’s low-minimum investment options, and know that your investment is in the most capable hands!