Depreciation on rental properties reduces real estate owners’ taxable income and income tax bills. Understanding the various factors involved in calculating depreciation to offset taxable income is important.
What is the depreciation process for rental properties?
Depreciating a large asset’s cost can be deducted over its useful life. Rather than one large deduction in the year of purchase, depreciation is spread over the property’s useful life. Rental properties can be depreciated if:
- The property belongs to you.
- Investments or businesses are conducted on the property.
- There is a one-year or longer useful life for it.
IRS tax rules mandate this concept. Property owners can only take a substantial amount of tax deductions at a time, even though purchasing a rental property costs a lot. Nevertheless, the property is a tangible asset that depreciates over its lifetime. When property owners deduct depreciation, they save money on purchasing and maintaining the property.
Depreciation of property begins when?
Renting or using the property for commercial purposes causes the property’s value to depreciate. During the recovery period, depreciation can be taken until the property is sold or the cost basis has been fully depreciated.
Before calculating depreciation costs, property owners must understand how to depreciate rental property. When a rental property is put into service, disposed of, or no longer used for business purposes in the same year, it cannot be depreciated. Despite meeting IRS depreciation requirements, this factor still applies.
Depreciation Calculation for Rental Properties
Calculate depreciation based on the cost basis and value of the property, the recovery period, and the depreciation method.
To calculate this figure, subtract the land value from the capital expenses of the property. In addition to paying the seller’s debts, recording fees, abstract fees, and legal fees agreed to by the seller and buyer, the buyer is responsible for paying for the seller’s debts. The cost of a property must increase when improvements are made.
The expected lifespan of the property determines the recovery period. An average deduction is made over the useful life of the property rather than deducting the costs incurred by wear and tear each year. A typical commercial property improvement lasts 39 years, while a specific residential property improvement lasts 27.5 years.
The Cost Basis
For calculating the annual deductible amount, depreciation is determined by dividing the cost basis of the depreciation-eligible portion by the property’s established useful life.
In other words, if a standard commercial property is placed into service with a cost basis of $200,000 for improvements, then a cost basis of $200,000 divided by 39 years results in a depreciation deduction of $5,128 every year until the investor recovers their investment or retires the property.
Alternatively, an investor could deduct $7,272 annually from the cost basis of a residential property with the same cost basis. The annual depreciation rate for residential rental property is typically 3.636% over 27.5 years.
You may have a different deduction amount for the first year if the property was not in service for the year, and you may have an additional deduction amount in later years if the property’s cost basis has changed significantly.
Depreciation under 1031 Exchange
Following a 1031 exchange, depreciation takes two forms:
- Each year, depreciation is calculated by dividing the new adjusted cost basis by 27.5 years.
- A two-schedule depreciation system divides the adjusted cost basis of the property sold by 24.5 years (first schedule) and the replacement property’s cost basis by 27.5 years (second schedule).
- Two-schedule depreciation is the preferred tax code method, though single-schedule depreciation is more straightforward.
- A 1031 exchange can defer depreciation recapture taxes. Generally, after a 1031 exchange, you receive the same depreciation rate for your replacement property as you did before.
- You continue using the old property’s useful life term regardless of its market value, and the cost basis of the new property is equal to the old one. Depreciating your replacement property for 29 years is eligible if you have declined your relinquished property for 10 of 39 years.
The Depreciation Calculation
The depreciation calculation may need to be more straightforward since the type of property you previously owned has changed, so the depreciation calculation may also be different.
The IRS requires that you calculate depreciation using the method which results in the least amount of depreciation.
When you continue the exchange cycle throughout your lifetime, deferred depreciation is eliminated along with deferred capital gains when your investment property is transferred to your heirs. A step-up in cost basis occurs when heirs inherit property at its current market value, so the accumulated depreciation no longer applies. Depreciation on rental properties can be found at investment.org.