How to Calculate Depreciation on Rental Property
Calculating depreciation for rental properties involves determining the cash basis for the property, separating the cost of the land from the building, and then adjust the cost of the building based on legal fees and improvements to the building. But what is depreciation, and why does depreciation matter in real estate investing? In this article, we’ll run down the basics for you, so you can learn the best ways to get back on your tax returns and earn the most out of the sale of rental property.
What is Depreciation?
Depreciation is the opposite of appreciation, involving deducing the costs of the property, taking portions of the costs of the building, and deducting it from your property taxes. Depreciation refers to the allocation of costs, not assessing its value. Properties don’t lose value, but rather increase over time, which means for an investor to take part in the sale of rental property, the investor will depreciate the property, even if it’s in perfect shape because it reduces the costs of purchasing the property for the buyer. Investors can write off the costs can from business through a few manners, such as keeping track of money spent and consumed immediately, tracking day-to-day- costs, and other small amounts of purchases.
However, for properties, these deductions can happen over several years. Depreciation, whether it’s for commercial real estate depreciation or residential real estate depreciation, can help finance the high costs of owning the property and help to increase its appreciation value over time until it’s time to sell.
How Are Properties Depreciated?
The IRS gives guidelines for depreciation, and that comes with a depreciation recovery period. Depreciation recovery periods help control the lifelines of properties and make applying for depreciation deductions an applicable, accessible asset for real estate investors. Commercial real estate depreciation typically has a more extended recovery period, averaging around 40 years when compared to residential real estate depreciation, which ranges from 25 to 30 years. For both of these types of properties, investors can take off the deductions when filing for tax returns as a way to manage your finances until you either sell the property or the entire cost basis for the property depreciates.
Side Note: Cost basis refers to the price you paid to the seller, additional costs to purchasing the property, and improvements made to the property. Adding improvements to a property can increase its depreciation recovery period and help improve the cost basis for the property.
What Property Can and Cannot Be Depreciated?
According the IRS Useful Life Table – IRS Publication 946, rental properties that can be depreciated must have these qualities:
- Owners must own the property.
- Owners must use the property for business or income-producing activity.
- The property must have a determinable useful life.
- The property must be able to last more than one year.
Examples of these kinds of properties include multi-family homes, residential rentals, cooperative apartments, and commercial real estate buildings. Even if the property has to debts, it’s still property in your name, which means you can claim depreciation. Your property must have the ability to produce income and have a determinable useful life. However, the IRS has a few exceptions to what can be depreciated. A few factors that cannot be depreciated include:
Land – To calculate depreciation, you must separate the cost of the land from the building. Land does not become obsolete or get used up. Even if the area does lose its value due to damages, the area loses accountability when applied to federal tax processing, and therefore cannot be depreciated.
Excepted Property – Properties that have been in service and disposed of within the same year or property that has equipment used to build capital cannot be depreciated. For properties that have equipment on them, they need to be depreciated under its fill form.
What Methods Can be Used to Depreciate Rental Properties?
To depreciate property, most investors will use the MACRS formula. The MACRS formula, also called the MACRS depreciation method, helps configure the numbers and information about the property to calculate depreciation. Much information for assets, such as tractors, office furniture, and cars, all have a certain amount of years that’s useful before the value of the asset decreases. With properties, the number of valuable years increases because its appreciation value increases and thus can annually be depreciated for tax returns based on this fact alone.
Under MACRS, there are two types of systems that investors and property owners can use to depreciate their assets, such as:
General Depreciation System – GDS uses declining balance methods for depreciating property. By applying the depreciation rate against the non-depreciation balance, the return deduction decreases over time until the useful life of the asset runs out, or until the cost basis for the asset reaches its limit. This system is used for most real estate properties.
Alternative Depreciation System – ADS are scheduled with a more extended depreciation recovery period, reflecting the asset’s income better than the GDS. However, to use the ADS system has smaller deductions than GDS, and when used, must be implemented across all properties of the same class. Some features require the ADS system under certain circumstances, including when:
- The property has business use 50% of the time or less
- The property has tax-exempt use
- Tax-exempt bonds finance the property
- The property is used primarily in farming
Another critical note to pay attention to when using the MACRS formula is how the depreciation recovery period affects those calculations. Depreciation recovery periods refer to a way of tracking the number of life years that a piece of property or asset has. Under MACRS, the recovery period is deducted for only 50% for the first year, while the other 50% the IRS writes off in the last year of the property for the depreciation recovery period.
For rental properties, according to IRS publication 527, you, as the investor and owner of the rental property, need to report multiple financial decisions made to the rental property, which include your rental income and rental expenses.
Rental income generally pertains to the type of income you receive, such as advanced rent, tenants paying other expenses, and types of services received as payment from tenants.
Rental expenses include factors such as insurance premiums, mortgage interest statements, amount of points received, and repairs and improvements made to the property. Through this, you’ll need to keep accurate records of all of your assets, inside and outside of the property. For a more generalized understanding of how to depreciate property, look at the IRS Useful Life Table – IRS Publication 946 for more information.
What is Depreciation Recapture?
When you decide to take part in the sale of rental property, at the end of your depreciation recovery period, the IRS will require some of those depreciation deductions to be returned. Selling a property typically involves paying for long-term capital gain taxes. Your income level determines the tax rate you receive, and with depreciation, you can accept higher returns for your taxes. The IRS, if you’re selling the property, will want a depreciation recapture alongside your long-term capital gain taxes. The Depreciation recapture will then apply to the lesser of the gain of your depreciation deductions at the end of the sale. It doesn’t apply when you sell for a loss, as you would then have to report the damage to the IRS as a Section 1231 loss.
The Steps for Calculating Depreciation for a Rental Property
Now, you, as the investor, can begin your calculations and prepare for your tax returns for the upcoming years. Here’s how you can begin your depreciation calculations when using the MACRS formula:
Determine the cost basis – First figure out what the costs of the rental property are, whether you paid in cash, with a mortgage, or another manner. Any amount that you’ve agreed to pay to the seller when you first purchased the property are all included in the cost basis for the rental property. Those amounts can consist of legal fees, recording fees, transfer taxes, and title insurances. Some expenses cannot be included, such as are fire insurance, rent related to pre-closing, and refinancing loan charges.
Separate land and building – Because you can only depreciate the building and not the ground, these two aspects of your purchase need to be separated. Use the fair market value during the time you purchased the rental property to determine the basis of the building. You can also use the estimate the number on the assessed real estate tax values.
Determine your basis in the house – After separating the land from the building, you can determine the basis of the building through real estate tax assessments and fair market value of the building.
Determine the adjusted basis, if necessary – Once you figured out the cost basis, you might need to make adjustments to the basis. The investor can add these modifications to the cost basis in between the purchasing of the property and the time you’ve placed the property up for rent. Some examples of adjustments include improvements to the building, costs of installing utility services, and other legal fees.
After these steps, you’ll be able to report your cost basis for the rental property to the IRS and begin depreciating your estate for tax returns until you’re ready to sell.