Table of Contents
- What Are Netting Escrows & How Does It Work?: The Best Guide - January 2, 2024
- The Secret About Prescriptive Easement: Top Guide 1 Must Know - December 4, 2023
- About Home Equity Loans In Texas And How Can One Obtain It - November 27, 2023
About Rental Property Depreciation
As a real estate investor, there are lots of things that you might have to consider to have a successful real estate portfolio.
You may have heard about many parameters from net operating income, to return on investment in your real estate investment purchase process.
Paying tax on your investment property income is also one of the significant factors that you have to keep in mind. In this post, we will understand what rental property depreciation is in detail.
What Is A Rental Property Depreciation?
Depreciation of rental properties allows investors in the market to take advantage of tax deductions for their investment properties.
This is done by proving to the IRS that the investment property in question has a deductive useful life. Once the useful years of the property are derived, you can use a formula to calculate the annual depreciation and the lost amount which can be used to claim as a deduction in your income tax with IRS.
The useful lifespan of the rental property is based on the type of asset you own. While residential property depreciates over 27.5 years, commercial property has a useful lifespan of 39 years.
To calculate your annual depreciation amount, you can divide the cost basis by a specified number of years based on your rental property type whether it is residential or commercial.
Note that only the value of the structure or building itself, and not the land it sits on, can be used to calculate the cost basis, as only the building has a useful life.
You can continue to claim depreciation until the property has been sold or you’re property reaches its full useful lifespan.
What Is Cost Basis And How To Calculate It?
The cost basis is the total price paid to purchase the property minus the value of the land on which the building or the structure is located.
The cost basis would also include any other cost paid by you to acquire the property such as legal fees, recording fees, escrow fees, inspections, transfer taxes, title insurance, and any expenses made towards home improvements.
For example, if you bought a rental property for $200,000, and the cost of the land is $80,000. You paid $5,000 in all the fees, and you did home improvement worth $5,000.
Cost basis = 200,000 – 80,000 + 5000 + 5,000 = 110,000
Your cost basis for the property for example would be $110,000
How To Calculate Annual Rental Property Depreciation?
Most residential rental properties would calculate the depreciation on rental properties with the help of the general depreciation system (GDS).
According to the rules of The Modified Accelerated Cost Recovery System (MACRS), most taxpayers will use GDS.
As explained in the law, a useful lifespan of 27.5 years is provided for residential, and a useful lifespan of 39 years for commercial rental properties. GDS uses a straightforward calculation to determine the depreciation amounts. Below is the formula.
Rental Property Depreciation = Cost Basis / 27.5 or 39
Let’s take our above example of residential rental property where the cost basis was $110,000 and calculate the annual depreciation amount using the above formula.
Annual Depreciation Amount = 110000 / 27.5 = 4000
In our above example, the annual property depreciation amount would be $4,000 that you can use to deduct from your total taxable income.
What Are The Conditions For Claiming Rental Property Depreciation?
To be able to claim the tax depreciation of a rental property, several conditions must be met:
- It must be income-generating property, generally, most rental properties are.
- The property must belong to you. There are rare exceptions to it.
- You should be able to know the useful lifespan of your rental property. It will differ according to the type of property subject to depreciation. Everything has a different life cycle or rate at which it wears out.
- The useful lifespan of the rental property must be more than 1 year. Anything that sells out in less than a year cannot be tax-deducted.
Conclusion
Depreciation of rental properties helps those who invest in rental real estate to significantly reduce – and sometimes eliminate – the amount that is paid in taxes.
The practice of rental property depreciation can also provide a way to get more profits from your rentals and increase your investment portfolio, without incurring additional costs.
You can calculate your cost yourself; however, it is recommended that you contact your trusted accountant to help you file your tax returns properly.
