The prime highlights of investing in real estate are the benefits it provides to property investors. Rental income is the obvious go-to in terms of profit, but there are a variety of other benefits investors may enjoy. Real estate appreciation and tax benefits, for instance, can be what makes a major difference for a lot of investment properties. Tax benefits, particularly tax deductions, lower an investor’s tax liability by allowing him/her to write off various expenses. Common tax deductions of expenses include property taxes, repair and maintenance costs, mortgage insurance, and much more. Today, we’ll be talking about a specific type of tax deduction: rental property depreciation.
What Is Rental Property Depreciation?
There is a lot to be discussed about real estate depreciation. We’ll start by breaking down its definition and how it is different than other depreciable assets.
Typically, depreciation of an asset is defined as its loss in value over time, usually due to wear and tear, deterioration, and age. An investment property, however, generally undergoes real estate appreciation, or an increase in value over time, as opposed to value depreciation. That’s why depreciation on rental property refers to something else entirely. Real estate depreciation is the deduction of costs associated with buying and improving a rental property, not a depreciation of property value itself. By depreciating these expenses, investors can increase tax savings and minimize tax liability.
The costs and fees associated with depreciation include anything used to improve and increase the property’s value. Only the improvements of the property structure, and not the land, can be depreciated. These expenses are spread out over the course of the useful life of the property. Some common examples of such rental property improvements depreciation include:
- Building a garage
- Upgrading the roof
- Adding new appliances
- Installing heating and/or air-conditioning
When Is a Property Eligible for Real Estate Depreciation?
So, how does rental property depreciation work? Are all investment properties qualified for depreciation gains? In order for a real estate investor to deduct depreciation on a property, it must meet the following rental property depreciation rules set by the IRS:
- The real estate investor must own the property. It cannot be rented or borrowed from someone else. The investor must be the owner, even if the property is subject to debt.
- The property must be used as an income-producing property. Rental properties, or other income-generating properties, are permitted.
- The property’s ‘useful life’ is able to be determined. The property must wear out eventually, which does not apply to pieces of land real estate. The property’s useful life must be more than one year.
How Long Does Rental Property Depreciation Last?
You now understand why rental property depreciation is great for real estate investors. Next, we need to answer another important question: How long is the residential rental property depreciation life?
When Real Estate Depreciation Begins
Rental property depreciation will begin once the property is available to be rented out by tenants. What’s great is that the property does not need to be rented out for residential rental property depreciation to begin. As soon as the rental is listed and advertised, it is eligible for rental property depreciation.
Two Important Conditions
A property will continue to depreciate until one of two situations occur:
- The entire cost or basis of the property has been deducted.
- The property no longer functions as an income-generating rental. This happens regardless if its entire cost or basis was fully recovered. An investment property will meet this condition if it is retired as a rental, converted to personal use, sold, exchanged, abandoned, or destroyed.
An important note to the second situation is what is known as rental property depreciation recapture. This occurs when a property is sold. Depreciation recapture on the sale of rental property happens when the property price exceeds the property’s tax basis. The difference between the two figures and the sale must be reported to the IRS as an income.
Properties that are temporarily not in use, however, still qualify for depreciation. This is applicable, for instance, to properties that are undergoing repair or renovation after a lease has expired, even if the activity takes months or longer.
How to Calculate Depreciation on Rental Property
So far we’ve covered many important questions regarding real estate depreciation, ranging from how to depreciate rental property and what is the depreciation duration of property. We’ll now tackle one final question: How to calculate depreciation on rental property?
While there are several methods for calculating depreciation, we’ll focus on the most accurate and applicable method to rental property depreciation. This method is called the Modified Accelerated Cost Recovery System (MACRS). The MACRS method is used and required by the IRS for residential rental properties. The reason why is that MACRS spreads depreciation and cost deductions over 27.5 years, which is the typical useful life of a rental property according to the IRS.
The number-crunching of the MACRS method is complicated and is best reviewed with a professional. However, to understand how the MACRS method works and how to calculate depreciation, check out these steps.
1. Determine the Cash Basis of the Property
In order to determine the cash basis of the property, real estate investors need to sum the costs of acquiring the investment property, cost of improvements, and settlement fees.
2. Clearly Define the Cost of Property and Land
As mentioned previously, only the rental property itself can be depreciated. The same is not true for the land the property is on. Investors need to clearly compile the investment property’s costs and separate them from the land’s costs.
3. Determine the Basis of the Building
Next, the value of the building, using the basis of the property and land, is determined.
4. Determine Adjusted Basis
If needed, the basis of the building will be adjusted. Adjustments are made for specific events that occurred between purchase and rental activity. Certain legal fees and improvements, for instance, will be included to increase the building’s basis.
Rental property depreciation is one of the best deductions that lead to tax savings. With the information mentioned in this blog, investors will be armed with a comprehensive understanding of depreciation. Be sure to consult a professional when calculating your rental property depreciation. For more on depreciation and other real estate investing concepts, check out the Mashvisor blog! To start searching for an investment property, click here to start your 14-day FREE trial with Mashvisor!