Depreciation is the process of deducting the value of the asset and any improvements against your taxes. Find out more in this article.
Depreciation is the process of deducting the value of the asset and any improvements against your taxes. Depreciation in real estate then allows you to deduct the value of the rental property over what is deemed its useful lifetime by the IRS, which is, for residential rentals, 27.5 years.
Depreciation is one of the major tax benefits of being a real estate investor and can mean the difference between making a loss and operating a profitable portfolio. However, the IRS has very specific rules regarding depreciation, and it’s also important to know that a portion of the depreciated amount will be reclaimed back by the IRS upon the sale of the property. This process is called depreciation recapture.
In episode 10, guests Amanda Han and Matt MacFarland take us through the ins and outs of depreciation, cost segregation, and how record keeping is the foundation of any tax strategy.
Rental properties generally fit into the bracket of depreciable assets as long as they meet the following requirements:
As an additional note, it is only the physical building, not the land itself which is depreciable. The land is not seen as having a useful life but rather as an appreciating asset. Because of this you often can’t depreciate improvements made to land through exercises like landscaping.
Generally speaking, you can begin the process of depreciation as soon as the property is placed in service. For a rental property, this means when the property is ready and available to use as a rental which is evidenced by the date you actively start looking for tenants.
For example, you buy a property on the 1st of January. The property needs some work is done which takes 3 months to complete. On the 1st of April, you put the property on the market, advertise online, etc., and start actively looking for tenants. You find a tenant and they move on the 1st of May.
In this scenario, you can begin depreciating the property on the 1st of April, as this is when it is deemed to have been placed in service, ready for use.
You can then continue to depreciate the property until you have either deducted the entire cost, spread over those 27.5 years or you sell or dispose of the property, retiring it from service.
Any property put on the market after 1986 is depreciated using the Modified Accelerated Cost Recovery System (MACRS), an accounting technique that spreads costs (and depreciation deductions) over 27.5 years.
To determine how much you can depreciate in any given year you need to work out the cost basis of the property minus the value of the land. Some settlement fees and closing costs, including legal fees, recording fees, surveys, transfer taxes, title insurance, and any amount the seller owes that you agree to pay (such as back taxes), are included in the basis.
Because this can become quite complex, it is recommended that you work with a qualified tax accountant when calculating the depreciable amount.
Your cost basis is the initial value from which any future depreciation is taken. This is worked out by calculating the overall value of the property itself independent of the cost of the land and including certain qualified closing costs.
If you purchased the property for the purpose of renting it out, then you can likely take the purchase price as the properties value. However, if you lived in the property first, or you inherited the property you may need to get the property appraised by a professional to calculate the current property value.
As mentioned, once you have the property value you need to subtract the value of the land – only the building itself is depreciable.
You can also include certain qualified closing costs. These include:
For example, if you bought a property for $260,000 you calculate the land is worth $60,00 and there are $5,000 of qualifying closing costs, the cost basis of the property would come out as $205,000, which would be the amount you would then be able to depreciate.
The next step involves determining which of the two MACRS applies: the General Depreciation System (GDS) or the Alternative Depreciation System (ADS). GDS applies to most properties placed in service, and in general, you must use it unless you make an irrevocable election for ADS or the law requires you to utilize ADS.
ADS is mandated when the property:
Again, it’s recommended that you consult a qualified tax accountant, who can help you determine the most favorable way to depreciate your rental property.
Depreciation recapture is a process put in place by the IRS to recapture some of the deducted value of the property when you sell it. According to these rules, the amount deducted over time through depreciation is treated as capital gains which are taxed at a specific depreciation recapture rate when the property is sold.
In 2019, depreciation recapture on gains related to the sale of the property was capped at a maximum of 25%. The rest will be taxed at the long-term capital gains rate according to your income level. If you’re a higher-income taxpayer, you may also be on the hook for a 3.8% net investment income tax.
Let’s run through a simple example.
You buy a property for $100,000. You use it as a rental property for 10 years. You claim a deduction of $3,636 each year the property is in service.
The property then sells after 10 years for $150,000. Upon the sale of the property, you will need to pay capital gains tax on the profit. In this scenario, because you depreciated the property for 10 years you would make a profit of $50,000 plus the $3,636 x 10 years, making a total taxable capital gain of $86,360
This taxable gain would then be subject to two different tax rates. $36,360 would be subject to the depreciation recapture rate of up to 25% and the remaining $50,000 would be subject to your long-term capital gains rate of 0%, 15%, or 20% depending on your income level.
You might be looking at a loss if you have to sell a rental home in a down market or have just had to put more money into a property than it is worth. If you do make a loss when selling your property depreciation recapture doesn’t apply. However, you need to make sure you have correctly worked out your net gain or loss.
To determine if you have a tax gain or loss, you will need to compare the property’s sale price to its tax basis. The tax basis is generally your original purchase price, plus the cost of improvements (not counting expenses you’ve deducted as repairs and maintenance), minus any depreciation deductions you claimed while you owned it.
For example, you bought a property for $200,000 depreciated $58,000 over 8 years, and then sold the property for $150,000. This might look like a big loss, however, it would actually be an $8,000 gain which would be subject to depreciation recapture.
It might seem reasonable that if you were to avoid claiming depreciation you could avoid the recapture tax hit. However, this strategy doesn’t work because tax law requires that recapture be calculated on depreciation that was “allowed or allowable,” according to Internal Revenue Code section 1250(b)(3).
In other words, you were entitled to claim depreciation even if you didn’t, so the IRS treats the situation as though you had. From a tax-planning perspective, taxpayers should generally claim depreciation on the property to get the currently associated tax deduction because they’ll have to pay tax on the gain due to the depreciation anyway when they eventually sell.
What you can do however is delay capital gains by taking advantage of Section 1031 of the IRS tax code. Commonly referred to as a 1031 exchange, this section allows investors to defer paying taxes when they sell investment real estate, instead, they are allowed to reinvest the proceeds from the sale in a real estate investment of equal or greater value. You should always contact a 1031 exchange specialist before selling your property.
Investing in real estate is a great way to build wealth through an appreciating asset and achieve financial freedom. The US currently has some very favorable tax laws for real estate investors which makes it very possible to make great returns through rental properties.
To ensure you make the most out of your real estate investments and properly take advantage of all the deductible expenses available to you need to make sure you accurately and efficiently track your income and expenses, including things like rental property depreciation, and keep well-organized records for future reference.
The examples used in this article are simplified to explain the basics of depreciation and depreciation recapture. There are additional things to consider such as depreciating the costs of improvements to a property.
Additionally, rental property tax laws are subject to frequent changes which further complicates matters. As such, even if you’re familiar with and comfortable with filing your taxes, it is always recommended that you consult with a skilled and knowledgeable tax professional. Doing so will allow you to properly take advantage of the favorable tax laws and avoid any nasty surprises.
Here are some additional resources from the IRS website regarding depreciation that you might find helpful and informative:
We hope you found this blog interesting! However, do note that the information in this article does not constitute advice. This blog is for general informational and educational purposes only and should not be used as a substitute for competent legal and/or other advice from a licensed professional.