Real Estate Investing 101: How to Calculate Depreciation on Rental Property
With all the benefits of investing in real estate, there is nothing that could top rental property tax deductions. Among the various tax benefits, there is one that is the most beneficial for real estate investors: real estate depreciation. Therefore, I have put together this guide on how to calculate depreciation on rental property for beginners who are starting in residential real estate investing to help ensure that they take advantage of it!
Related: Investment Property Tax Deductions When Buying or Selling Real Estate as an Investor
What Is Rental Property Depreciation?
Unlike real estate appreciation, property depreciation is a form of tax savings just like any other tax deduction. However, the concept here relies on the fact that the investment property gets used and worn out after a while. Therefore, the value of the property decreases and that’s why there is a tax refund. So, in essence, this is not a property expense, but rather a sort of compensation for the usage of the investment property over time considering the fact that you will have to do some sort of renovation to it during its useful life span. Also, it is different from other tax expenses in the sense that you receive it over the course of the useful life of your residential rental property. In other words, instead of receiving it at once at the end of the year, you’ll be receiving it in the form of small amounts over the years.
Now, before we move on to how to calculate depreciation on rental property, here are the conditions and requirements for this type of tax benefit:
Requirements for Property Depreciation
First of all, not all types of real estate properties are depreciable. This concept only applies to the following criteria:
1. The property is registered under your name even if it is subject to a debt. This means that even if you have a mortgage or a loan or any other obligations associated with the property, if you are the owner, then the property is depreciable.
2. The property must be an investment property. Meaning, only income-producing assets are subject to depreciation.
3. The investment property is subject to being worn out or used up in a way that causes a decrease in its value over time.
4. The investment property must last for a year at the very least. This means that you cannot depreciate a property that is expected to be demolished within a year, for example.
However, you should note that, in some cases, meeting the criteria above doesn’t mean that depreciation is applicable. Therefore, you cannot depreciate the land on which the property stands. Moreover, you cannot depreciate any costs relative to the land lot such as landscaping.
So, when does depreciation start?
The depreciation process counts from the day on which the investment property was ready for renting out. For example, you buy a below market value property that is in a distressed condition on January 1st. You renovate the property but the process takes three months and on April 1st you put it up for rent. You find a tenant and the lease starts on June 1st. When does depreciation start? It simply starts on April 1st when the property was ready for business.
How long can you keep depreciating the rental property?
You keep depreciating the property until one of two scenarios occur:
1. You keep deducting until you reach the property cost limit or any other major basis in the property.
2. You no longer use the property for income producing purposes.
An important thing to point out is that you can still depreciate the investment property if it’s empty but is being prepared for the next tenant to take over. So, let’s say your tenant moved out and you’re renovating the property for the next tenant to move in. Even if it takes two months to do so, the property is still subject to a depreciation deduction. Another significant fact is that when you sell the property, there is what we call depreciation recapture. You must report the sale to the IRS at that time. It happens when the property price exceeds the tax basis and you must report the difference in value as an income.
Related: Real Estate Renovation: How Will It Affect Your ROI?
How to Calculate Depreciation on Rental Property for Taxes
1. Calculate the basis of your rental property
The basis of the rental property is whatever price you paid for it regardless of the investment property financing strategy you used. It also includes a number of fees such as title insurance, legal fees, and transfer taxes. However, you can’t include some fees when calculating depreciation on the rental property such as refinancing charges.
2. Separate the cost of land and building
As we have mentioned before, the building itself and the costs associated with it are the only depreciable costs. Therefore, you must separate the cost of the land from the overall value of the property. One way to do that is by going back to the fair market value of each the land and the building at the time you purchased it. You can also hire a real estate appraiser.
Related: When and Why Do You Need a Home Appraisal?
3. Determine the adjusted value
Since you have separated the land cost from the building cost, it is time to determine the adjusted basis of the building. In other words, you must add all the expenses associated with the house to its value and base your depreciation amount on that number.
The Advantages of Property Depreciation
As a real estate investor, it’s important that you understand and take advantage of all the benefits of buying a rental property. In this case, rental property depreciation can save you hundreds, if not thousands, of dollars on an annual basis. And if you are a residential real estate investor, the useful life period the IRS has set for residential property is 27.5 years. So, imagine how much money you can save from the single idea that your property is losing value due to constant usage as an investment property.
Keep in mind that while it’s important to know how to calculate depreciation on rental property as a real estate investor, you should also seek professional help from a tax advisor or real estate agent to get the most accurate calculation,
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