Are you wondering how rental property depreciation works and how rental property depreciation saves you money on your taxes? Forget the confusing legal and tax websites, we’ve got you covered.
Rental property depreciation is when every day life takes a toll on a rental property that you own. This includes the wear and tear on the floor boards, natural damage to the frame and foundation of the unit or building, and everything in between. Because rental properties naturally depreciate from wear and tear reducing the value of your asset, the IRS has a tax benefit for you as the owner.
Now that you know what causes rental property depreciation and that you can use it for a tax break, here’s how rental depreciation works as and some frequently asked questions.
How to Determine Rental Property Depreciation
Property depreciation value is dependent on the useful life of the property. The IRS says for rental properties put into service in 1986 or later, the useful life is 27.5 years (based on the Modified Accelerated Cost Recovery System (MACRS) accounting technique).
To find your annual depreciation costs, calculate 3.636 percent of the home’s original value and claim that amount as an expense on your taxes. This 3.636 percentage rate is the equivalent of taking your home’s value and dividing it 27.5. The rental property depreciation distributes the amount across the useful life of 27.5 years.
In order for depreciation to be applicable, not only does the property need to have a determinable useful life beyond a single year, but the taxpayer must be the legal owner of the property. Additionally, the property must be used to produce income.
How To Calculate Rental Property Depreciation
Because only the value of the home can be used to determine depreciation expenses, a few steps must be taken during the calculation. The value of the buildings must be separated from the value of the land.
What does this mean? The property will sell as a whole at a set price. Only a portion of that price will be what the home is actually valued at while the other portion is what the land is valued at. Depreciation only applies to the value of the home and not the land. This is because land doesn’t lose value over time.
The tricky part about depreciation value is that it does not apply until the property is put into service. In the case that a property is purchased a portion of the way through a year, you will not be able to claim the 3.636 percent you would be able to during a year when a house has been in service for an entire year. Instead, you would only be able to claim a portion of that.
To simplify things, the IRS has developed what it calls the Residential Rental Property-GDS Table that helps investors find what percentage they can claim.
- January: 3.485 %
- February: 3.182 %
- March: 2.879 %
- April: 2.576 %
- May: 2.273 %
- June: 1.970 %
- July: 1.667 %
- August: 1.364 %
- September: 1.061 %
- October: 0.758 %
- November: 0.455 %
- December: 0.152 %
This table makes the process extremely simple. To find out what can be claimed at the end of the year, you take the cost of the property and find the percentage that applies to it based on the respective month that the property was put into service.
For example, if rentals begin in April of $100,000 home, the owner will be able to claim 2.576 percent of the $100,000 for that year, which is $2,576.
Once you hit a certain depreciation point, you may want to re-run your numbers and consider renovating the property to sell as a fix and flip. The property can only depreciate according to the value provided by the IRS.
What to do When Rental Properties Depreciate to Non-profitable Standings?
There are a lot of things you can do once your rental properties depreciate past profitability. The most popular option is depreciating the money spent on improvements. An improvement differs from repairs as to be considered, so they must be something that improves the property’s condition, enhances the property value, or adapts the property for new use.
Some examples of improvements that can be depreciated are replacing the roof, buying new appliances, adding a garage, or installing heating or air conditioning.
To stay ahead of the game and keep maximum cash in your pocket, you may want to consider renovating and flipping the property. But if this is the route chosen, you will need to anticipate depreciation and how that will factor into the capital gains tax. Also know that your total investment will be offset by these factors to make sure you make a profit when the time comes to sell. You may also want to check out selling on a 1031 exchange.
Do You Have to Pay Back Rental Depreciation on a Property?
Yes, you will need to pay back rental depreciation if you sell the property. If you’ve applied the depreciation deductions, the IRS will calculate the deductions into the total profits in the capital gains tax.
In some cases, the 1031 exchange can be filled out to help you avoid the capital gains tax. Sellers should consider this if they are interested in investing the proceeds from the sale to invest in a comparable property.
How Long Can You Depreciate Improvements on Rental Properties?
Improvement depreciation follows a five- to 15-year schedule based on the improvements useful economic life. Despite being considered a part of the home, improvements are not going to fall in line with the useful life of the property on account of their own subjective flaws and weak points. Because of this, they will need to be re-evaluated each year to ensure they are up to par with their respective service lives.
Please remember that tax laws and the rules for depreciating your rental properties can change. It is important to always talk to a licensed tax professional to get an up-to-date look at what you are depreciating and if you have any other opportunities to save money.