Rental Property Depreciation: What Is It And How Does It Work?
Rental properties give investors the opportunity to gain passive income. However, like any home, there are going to be things that break down and need maintenance over time. To help compensate for this expense, one of the things you can claim is rental property depreciation.
If you’re getting ready to buy a rental property, this article will go over what rental property depreciation is, how it works and how to report it for the tax benefit. Finally, we’ll go over how to calculate your depreciation.
How Does Real Estate Depreciation Work?
Rental property depreciation allows real estate investors to take tax deductions for their property. This is done by convincing the IRS that the property in question has a determinable useful life.
Once the useful time frame of the property is determined, you can use a formula to calculate the amount of value lost due to depreciation each year and claim the deduction on your taxes. While this article will walk you through the basics, any questions on your specific situation should be directed to a tax advisor.
Reporting Rental Property Depreciation To The IRS
Depreciation of rental property is generally reported on Schedule E of a standard 1040, although there are situations in which you would use other forms. For example, Form 4562 may be used if you claim depreciation on a property in the year that you put it into service as a rental property.
There are situations in which other tax forms may apply. If you have any concerns over which one is right for you, speak with a tax preparer or financial advisor.
Typically, those who rent out their residential property have to report their rental income on their taxes. The exception to this is if the property is used primarily as a home and rented out for 15 or fewer days. You’re not allowed to deduct rental expenses for the property if it’s rented out for this amount of time, either.
Claiming Rental Property Depreciation
To claim property depreciation as a deduction on your taxes, several conditions have to be in place:
- You must own the property. There are limited exceptions to this.
- The property must produce income for you. Rental property certainly qualifies.
- You must be able to determine the useful life of your property. It’s going to be different based on the type of property being depreciated. Everything has a different life cycle, or rate at which it wears down. For real estate, this is somewhat standardized.
- The useful life of the property must be greater than 1 year. Nothing that wears out in less than a year can be depreciated on your taxes.
Since we’re on the topic of real estate, one item that specifically can’t depreciate is property put in service and sold in the same year. This likely won’t come up very often, but if you were to start renting out your home and then decide being a landlord is no longer for you or can sell the property for a quick profit in the same year, you can’t claim depreciation.
Useful Life Of Properties
The IRS has standardized what’s considered the useful life of property. For the purposes of real estate, here’s what you should know:
- Choice of depreciation life cycle: There are two different systems: the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). If your property is being used in certain businesses, you may be required to use ADS. Otherwise, you have the option to choose between the two. For either nonresidential or residential real property (defined by the IRS as land and anything that’s built on or attached to it), you can choose either system on a property-by-property basis. Once you select a system, you must stick with it for as long as you claim depreciation on a particular property. ADS generally has longer life cycles than GDS, but the level of depreciation that may be claimed each year isn’t as high under ADS.
- Residential rental property: The useful life of residential rental property under GDS is 27.5 years. Under ADS, it’s 30 years (or 40 years if the property was placed in service – rentable – prior to January 1, 2018).
- Nonresidential real property: Under GDS, the life cycle for nonresidential real property is 39 years. ADS has a 40-year time span for this property class.
- Land: Land can’t be depreciated because it doesn’t wear down.
How To Calculate Rental Property Depreciation
Calculating property depreciation is a three-step process that involves determining your cost basis, dividing by the property’s useful life under your chosen depreciation system and calculating a depreciation schedule.
Determine Your Cost Basis
Your cost basis (i.e., the initial value from which any future depreciation is taken) is dependent on your property value plus certain qualified closing costs.
If you’re buying the property as an investment property, the property value is likely the purchase price. If the property is being converted to a rental after you’ve been living there a while, your best bet may be to get a professional real estate appraisal.
When calculating the cost basis of a property, the value of land isn’t included, so you want to make sure to only include the value of the house for tax purposes.
To the property value, you can add certain qualified closing costs. These include:
- Property taxes: If you agree to pay the real estate taxes for the seller, these can be added to your cost basis, as long as you don’t also deduct them as local taxes paid elsewhere in your tax return.
- Abstract fees: As part of the title work, someone writes up a description of the property.
- Charges for installing utility services: Think gas, electric and water hookup.
- Recording fees: A record of the transaction is recorded with your local authorities. There is a fee for this.
- Transfer taxes: A transfer tax is usually calculated as a percentage of the sales price that local authorities get when a property transfer takes place.
- Legal fees: In some states, an attorney is required to be at closing. Even if they aren’t required, you might still wish to have an attorney present.
- Surveys: A survey may be necessary to determine property lines.
- Title insurance: If you’re getting a mortgage, your lender will require you to get a lender’s title policy. An owner’s title policy will protect you if anyone comes along with a legitimate interest in your property that wasn’t discovered before you closed.
- Any other amounts owed that you agreed to pay: These could be back interest payments or real estate commissions.
If you buy an investment property for $200,000 and pay $6,000 in eligible closing costs, your total cost basis is $206,000.
Divide By The Property’s Useful Life
To calculate the annual amount of depreciation on a property, you divide the cost basis by the property’s useful life.
In our example, let’s use our existing cost basis of $206,000 and divide by the GDS life span of 27.5 years. It works out to being able to deduct $7,490.91 per year or 3.6% of the loan amount.
Calculate The Depreciation Schedule For Rental Property
It would be nice if everything were that simple. Sadly, it isn’t. The reason is that in the first year you have the property, you can only claim depreciation for as long as it’s been in service. Therefore, if you start renting the property in May, you have to pretend that you started renting in the middle of the month.
The IRS has tables that are provided at the end of Publication 946. Use the second chart in appendix A to determine which table will give you the percentage of depreciation to take in the first year. Since we’re using GDS on residential rental property with a mid month service assumption starting in May, you can take 2.273% depreciation in the first year.
Rental Property Depreciation FAQs
When it comes to rental property depreciation, there are many commonly asked questions. Here are a few.
What’s the rental property depreciation income limit?
When it comes to the rental property depreciation income limit, owners will need to have a gross income limit of $100,000 and are able to deduct up to $25,000. Real estate professionals who are rental property owners are allowed to deduct any amount of losses from their non-passive income.
What happens to depreciation when a rental property is sold?
Rental property depreciation can be very beneficial, but when you’re selling the property, it can be a bit tricky. Here’s an example to make it a bit easier to understand.
If your cost basis is $200,000 and your total depreciation is $25,000, the IRS will calculate the capital gains based on $175,000. If you end up selling the property for $250,000, the IRS calculates the capital gain tax with a profit of $75,000 instead of $50,000. This is called depreciation recapture.
What happens if I don’t claim depreciation on a rental property?
As a first-time real estate investor, it can be easy to overlook this tax deduction, especially if you do your own taxes. Luckily, you can claim your depreciation benefit after the fact on your recent tax return. By completing a Form 1040X and any other forms or schedules, you can amend your tax return to claim this tax benefit.
The Bottom Line: Rental Property Depreciation Can Be A Huge Tax Advantage
As a real estate investor, one of the expenses you can deduct is depreciation on your rental property. The depreciation deduction is meant to help offset the ongoing cost of maintenance on a property over time.
To qualify as a depreciating asset, you must own the property – and it must be something that will have value for more than a year. For real estate, depreciation timelines depend on whether it’s residential or nonresidential property and the depreciation system being used in the calculations. Land doesn’t wear away, so it’s not a depreciating asset.
To calculate depreciation in real estate, you need to know the cost basis, which is the value of the property itself minus the land, plus qualifying closing costs. This is divided by the useful life of the property according to the depreciation method being used. Finally, you need to use a depreciation schedule to calculate how much depreciation you can claim in the first year and over time.
For tax advice tailored to your personal situation, please speak to an accountant or tax advisor.
For even more real estate tips and tricks, check out the Rocket Mortgage® Learning Center.