The Basics Of Depreciation For Landlords
September 30, 2022
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What Are The Landlord Basics Of Depreciation?
In the world of taxes, depreciation is one of your best friends—it means more money in your pocket.
For that reason, depreciation can make a significant on your bottom line.
It can be complicated, though, so let’s take a look at the basics of depreciation and how you can take advantage of it in your rental property business.
What is Depreciation?
Over time, buildings and other kinds of property wear out and become less usable, and therefore decline in value. Depreciation is one of the most valuable annual tax rental property deductions that property owners and investors can take advantage of to make up for this cost.
However, in contrast to the interest you pay on a loan for the property or other operating expenses related to it, you cannot deduct the purchase of rental property in the year you buy it. Instead, you must deduct the cost of the property over an extended period because real estate lasts well over a year.
This long lifespan makes depreciation quite valuable because you get it year after year (for 27.5 years when it comes to residential real property), and you don’t have to pay anything more than your original investment in the property. Furthermore, your property will likely increase in value over time, and you’ll still get depreciation.
Let’s look at a specific example to get a better understanding. Suppose you purchase a rental property with a depreciable value of $300,000. Once you divide $300,000 by 27.5, you realize you’re entitled to an annual depreciation deduction of $10,909. The only thing you must do to receive these deductions is run the property as a rental, file a tax return each year, and maintain simple bookkeeping.
It’s important to mention that if you sell your property, you’ll probably have to pay a tax of up to 25% on the total depreciation deductions you got over the years. That being said, the annual depreciation lowers your yearly taxes. This means that depreciation lets you defer the payment of tax on your rental income from the years in which it was generated to the year you sell it.
Theoretically, depreciation is simple. In actuality, though, keeping track of your depreciating assets can be quite complicated. Therefore, it’s crucial to understand the basics of depreciation in order to apply them properly should things get sticky.
Most deductions are optional; depreciation isn’t. If you have property that qualifies, while also not qualifying for one of the three safe harbors, you must depreciate in step with the IRS’s guidelines.
Improvements that don’t meet the criteria for one of the three safe harbors must be depreciated. Here are the four elements needed to qualify for depreciation:
1. Long-term Property – The property must last longer than one year. In other words, these assets are part of your capital investment. For instance, buildings, cars, dishwashers, refrigerators, and lawn mowers each last longer than a year and are depreciable. Expenses that are not long-term property include food, fuel, and cleaning supplies for pools, which last less than a year and are operating expenses.
2. Property that Decays or Gets Used Up – The property must be subject to decay or have a finite usable lifespan. Buildings, pools, mobile homes, offices, landscaping, appliances, and carpets are all subject to wear and tear. Property that does not wear out includes stocks or bonds, land, and antiques.
Additionally, you can depreciate tangible personal property that lasts more than a year. Examples are stoves and furniture. Items like computers and cellphones can also be depreciated, despite not being on your rental property.
3. One Year Minimum Ownership – You must own the property for over one year. It doesn’t matter whether you had to borrow money to buy the property or not; if you have the title, you get the depreciation.
4. Rental Business Use – You must use the property for rental activity, not personal use. If you do use it for personal reasons (e.g., you use your mower for your home’s lawn), you must depreciate only the percentage of the property used for your rental business.
How Depreciation Works
At a high level, depreciation works like this: You determine what the property is worth for tax purposes—the property’s basis—and how long the IRS says you need to depreciate it for—the recovery period.
However, the “fine print” is key to fully understanding depreciation. There are four things you need to figure out before you can pinpoint the depreciation:
Depreciation Starting and Ending Points
First, you need to figure out when depreciation begins and concludes. This can be a bit misleading because depreciation doesn’t necessarily commence right when you buy the property. Instead, it starts once the property is “placed in service.” A property isn’t at this stage until it’s prepared and available to rent.
The ending point occurs when you fully recover the value or retire it from service. Retiring a property from service involves concluding rental activities, selling the property, or destroying it.
Figuring Out Your Property’s Basis
Depreciation permits you to deduct your complete investment, also known as the basis, in a long-term asset that you purchase for your rental activity. Basis is a critical part of depreciation. It simply means the amount of your total investment in the property for tax purposes.
Typically, you calculate your basis by taking the total property investment as it relates to taxes. You will also need to add expenses tied to the sale, like title and transfer fees. And any improvements you make should be added as well.
The Recovery Period
The depreciation or recovery period depends on the type of property. These periods can be a bit arbitrary. That being said, items expected to last longer typically have longer recovery periods than property with shorter lifespan expectancy. For instance, software has a three-year period, the commercial property period is 39 years, and the recovery period for residential real property is 27.5 years.
The periods don’t change based on the property’s age. Once you purchase a property, you begin a new depreciation period starting with year one. If you buy a complex that has had numerous prior owners, it’s probably been depreciated several times. It has no bearing on your depreciation.
Determining Your Deduction Amount
The depreciation deduction is a fixed percentage of the basis of your property each year. The figure relies upon the depreciation method you use. Real property must be depreciated with the straight-line method. The rental property depreciation schedule for this method means that you deduct an equal amount every year over the period.
Personal property can be deducted over its entire recovery period using accelerated deduction. This method gives larger depreciation deductions in the initial years than the straight-line method.
Depreciation reflects the decline in value of an asset over time. So, what happens when the value goes up over time, as it does with many properties?
Depreciation still lowers your taxes, but when the property value goes up, the IRS wants to “recapture” the taxes you’re now avoiding.
So, the IRS gets the taxes they want back when you sell the property. They tax the portion of your sales profit related to the depreciation deductions. This is known as rental property “depreciation recapture.” Recapture works well for you in the near future because it gives you more access to capital, but it ensures that you will pay a higher tax later when you sell your property.
Recapture makes it so that same-year deductions are typically more profitable than depreciated deductions.
Knowing the basics of depreciation is key to getting the most out of your taxes. When you understand the nuances of depreciation, you can save money and use taxes to your advantage.
There are more details than we’ve covered here, so do some research and talk to a professional accountant if you have an unusual tax situation.