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A must read for real estate investors come tax season.
If you own a rental property like me, you’re likely eligible to take a depreciation deduction on your taxes each year.
This deduction can save you a significant amount of money on your tax bill each year … but how does depreciation work for a rental property?
How do you calculate it?
Are there any deductions when you’re talking about rental property depreciation?
Don’t worry; we’ve got you covered with answers for all these questions and much more!
Here’s everything you need to know about rental property depreciation and how to calculate it.
Depreciation is a tax deduction that rental property owners can take each year.
The depreciation deduction accounts for the natural wear and tear on a property over time, as well as a potential loss of value as the market fluctuates.
Depreciation happens over a period of 27.5 years. Each year in that period, you’ll deduct a percentage of the building’s value from your taxable income based on your calculations.
It’s important to note that depreciation is calculated based on the value of the building, not the value of the land.
After the 27.5 year period is over, owners can no longer take depreciation deductions on the property.
The 27.5 years starts over when the property is sold to a new owner.
Got it?
You can also take depreciation deductions for major upgrades to your property. For example, if you put a new roof on your property or updated the appliances, you would be able to take a depreciation deduction for these improvements.
Depreciation periods for these items vary—for example, appliances depreciate over a period of five years.
In order to qualify for a rental property depreciation deduction, you’ll need to meet specific requirements set out by the IRS. The qualifications for this deduction are:
If your property does not meet these standards, you cannot take the rental property depreciation deduction.
Deductions help you reduce your total taxable income. When calculating your taxes, you will subtract the deductible amount from your yearly income before calculating taxes owed.
Rental property depreciation is a sizeable deduction for most landlords, so it’s important to include on your taxes if you qualify for it.
This is just one of many deductions that you as a landlord can take as part of your taxes.
Here’s a step-by-step look at how to calculate your rental property depreciation:
Your cost basis is the value of the building and any qualifying closing costs, minus the value of the land it sits on.
For example, if you bought a property with a land value of $75,000, a total value of $500,000, and qualifying closing costs of $5,000, your cost basis would be $430,000: (500,000 + 5,000) – 75,000
Properties put into service after 1986 can use the General Depreciation System as part of the Modified Accelerated Cost Recovery System.
This means that you can calculate depreciation by dividing your cost basis by the recovery period, which is 27.5 years for residential buildings.
For residential buildings, this comes out to a rate of 3.6% per year.
If your property was put into service before 1986, you may need to use an alternative depreciation rate. It’s best to consult a real estate tax expert in this scenario.
Once you know your depreciation rate, you can calculate your total deduction amount for the year.
For example, if you have a residential property with a cost basis of 200,000, you can deduct $7,200 on your tax return.
If you have owned the property for less than a year, you will need to adjust your deduction for monthly depreciation.
The IRS has helpful resources online for calculating monthly depreciation rates.
Still have questions?
Don’t worry: next, we’ll take a look at some of the most commonly asked questions associated with rental property depreciation.
You will have to pay back rental property depreciation when the property is sold — this process is called recapturing.
When the property is sold and you receive the payout from the property, you will need to pay your regular income tax rate on the amount equivalent to your depreciation deductions. This rate is capped at 25%.
For example, if you sold a property for $500,000 and had taken $25,000 in depreciation deductions over the years, $25,000 of the profit would be taxed at your normal tax rate, while the remaining $475,000 would be subject to a lower capital gains tax.
Many real estate investors will use a 1031 exchange to avoid depreciation recapture and other taxes when selling a property. A 1031 exchange essentially allows you to swap one property for another of similar value.
When deducting depreciation for your rental property, you’ll fill out IRS form 4562.
If you use online tax preparing software, this will help you calculate depreciation as well.
Depreciation doesn’t start immediately after you purchase a property.
Instead, it starts after you put the property into use for your business.
For rental properties, this means you can start depreciation when you start renting out the property.
Don’t skip your rental property depreciation deductions when filing your taxes this year—they could save you a significant amount of money.
Don’t hesitate to seek help from a tax professional to ensure you’re correctly maximizing your tax deductions.
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