Owning a rental property can provide a slew of cash benefits including rental property tax breaks. When the property is rented, it generates a consistent stream of cash. Deductions for costs like insurance, property taxes, and property maintenance can reduce the tax owing on rental income. And because real estate tends to appreciate in value, you may be able to sell it for a profit.
Another advantage is depreciation, which reduces the investor’s tax payment over the life of the property. Depreciation is frequently used by investors to maximize their profits on any given piece of property while minimizing out-of-pocket expenses. These tax advantages may play a significant role in your investment decision. Let’s see how to calculate rental property depreciation in this post.<\/p>\n\n\n\n
Depreciation is the process of deducting the cost of purchasing or renovating the rental property. Depreciation spreads those costs throughout the property’s useful life.<\/p>\n\n\n\n
Assume you purchase a rental property. Rather than taking a substantial tax deduction in the year, you purchased the property, you would take a portion of the cost of the structure as a lesser depreciation deduction each year.<\/p>\n\n\n\n
You may have heard the term “depreciation” used to describe the decrease in value that occurs as a piece of property wears and tears. This is not entirely correct. Depreciation is the process of dispersing the expense of property rather than determining its value. Even if your rental property is in excellent condition, it will depreciate.<\/p>\n\n\n\n
The IRS estimates that a residential rental property has a useful life of 27.5 years in 2020. During that time, the property wears out \u2013 or depreciates \u2013 at least for tax purposes.<\/p>\n\n\n\n
If you are a real estate investor, you can deduct 3.636 percent of the property’s cost basis from your annual income to minimize the amount of income due to tax.<\/p>\n\n\n\n
You do not just deduct the cost of purchasing a rental property. Money spent to renovate the property is also devalued. Anything that increases the value or usefulness of a property restores it to new or like-new condition, or adapts it to new use is considered an improvement.<\/p>\n\n\n\n
The number of possible enhancements is limitless, but common enhancements include:<\/p>\n\n\n\n
Routine maintenance and repairs are not considered improvements. Maintenance costs are deducted as expenses in the year that the money is spent. For example, applying tar to a roof is considered maintenance, whereas replacing a full roof is depreciation.<\/p>\n\n\n\n
Depreciation deductions begin not when the property is purchased, but when it is used to generate rental income. This is referred to as “placing the property in service” by the IRS.<\/p>\n\n\n\n
Depreciation will continue until one of two things occurs:<\/p>\n\n\n\n
However, not all rental property components can be depreciated.<\/p>\n\n\n\n
For example, because the value of the land or lot does not decline, it cannot be depreciated. Routine operating expenses including property management fees, routine maintenance, and property tax are also not depreciated. They are instead deducted from gross rental income in the year in which they occur.<\/p>\n\n\n\n
Several conditions are mentioned in IRS Publication 527 that must be met in order to depreciate rental property:<\/p>\n\n\n\n
Because the property has been kept for less than a year, real estate investors who fix and flip cannot depreciate it. Wholesalers are also unable to claim a depreciation deduction because they never actually own the real estate they are selling<\/p>\n\n\n\n
You can calculate rental property depreciation in three steps: identifying your cost basis, dividing by the usable life of the property under your selected depreciation scheme, and computing a depreciation schedule.<\/p>\n\n\n\n
Your cost basis (the initial value from which you’ll calculate all future depreciation) is determined by the value of your rental property plus certain eligible closing costs.<\/p>\n\n\n\n
If you are purchasing the property as an investment, the property value is most likely the purchase price. If the property is being converted to a rental after you’ve lived there for a time, getting a professional real estate appraisal may be your best chance.<\/p>\n\n\n\n
Because the value of land is not included in computing the cost basis of a property, you should only consider the value of the house for tax reasons.<\/p>\n\n\n\n
Certain eligible closing costs can be added to the property value. These are some examples:<\/p>\n\n\n\n
If you pay $6,000 in acceptable closing costs and acquire an investment property for $200,000, your total cost basis is $206,000.<\/p>\n\n\n\n
To calculate the annual amount of depreciation on a rental property, divide the cost base by the useful life of the property.<\/p>\n\n\n\n
So, let’s take our existing cost foundation of $206,000 and split it by the GDS life lifetime of 27.5 years. It turns out to be $7,490.91 each year, or 3.6 percent of the loan amount.<\/p>\n\n\n\n
It would be lovely if everything was as straightforward as that. Unfortunately, it isn’t. The reason for this is that you may only claim depreciation for the first year you own the property for as long as it is in service. As a result, if you begin renting the property in May, you must pretend that you began renting in the middle of the month.<\/p>\n\n\n\n