Did you know that rental property depreciation can save you thousands in taxes each year? This tax deduction can help you recover the cost of your property over time. Could this work for your rental property? How do you calculate it? Maybe you’re wondering how it will impact your taxes. Learning how to determine depreciation on your rental property is a helpful tax-saving tool for rental property owners like you.
What is Rental Property Depreciation?
When something depreciates, it gradually loses value over time. This also applies to your rental property. If you own a rental property, you can recover the cost of the depreciating value over time via an annual income tax deduction. Essentially, you will receive an allowance for the wear and tear of your rental property. The Internal Revenue Service (IRS) does have specific requirements for rental property depreciation, requiring you to be the owner of the property, and you must be using it for rental purposes. It cannot include the value of land, and the property should have a lifespan of more than a year to be in service.
How to Calculate Depreciation
Figuring out how to determine depreciation on a rental property is dependent on a few things. You’ll have to determine the depreciable basis of the property by separating the land value from the building value. You can use the IRS-Defined Depreciation Method to determine your annual depreciation deduction. You’ll likely use the Modified Accelerated Cost Recovery System (MACRS). If your property was put into service as a rental before 1987, you’d use the Accelerated Cost Recovery System (ACRS).
To determine the basis of the property, you’ll need the purchase price, the closing costs, and the improvement costs added together. Be sure this total does not include the value of the land. Typically, residential rental properties are depreciated over 27.5 years. For example, let’s say you purchased the property for $170,000, closing costs were $5,000, and you did around $25,000 in improvements. The depreciable basis of the property would be $200,000, excluding the land, and then you’d divide by the years. This would give you $7,272 per year to reduce your taxable income by.
How to File Depreciation on Taxes
Forms to Use
When you file taxes, you’ll use Form 4562. You’ll claim your deduction for depreciation and make the selection to expense certain property. You’ll also submit Schedule E (Form 1040) to report income or loss from rental properties. You can attach your own schedule to report income or loss. To avoid confusion, you’ll notice this form has multiple purposes outside of rental property income and loss, like claiming income or loss from royalties, partnerships, estates, or trusts.
Common Mistakes to Avoid
When filing for rental property depreciation with your taxes, there are a few things to be wary of. Be sure you do not include the value of the land when determining the basis of the property. If you paid $400,000 for a property, that could likely include the value of the land aligned with the building. You’ll need to verify the value of the land and remove that before determining depreciation on your property. You could be missing out on valuable income if you don’t start depreciation in the first year your rental property is in service. As soon as you’ve acquired a rental property and have put it into service, go ahead and look into determining depreciation on the property.
Special Depreciation Rules and Considerations
There are a few special rules and considerations to keep in mind when determining depreciation on your rental property. When determining the property’s depreciable basis, be sure you’re aware of the difference between an improvement and a repair. Repairs include anything that brings the property back to its original value, like repairing a leaky faucet or minor repairs to your HVAC. Improvements are anything done that quite literally improves the value of the property, like adding a bathroom or renovating a bathroom. Any improvements to the land cannot be included.
If you sell the property, you need to be aware of recapture of depreciation. The IRS will more or less “recapture” depreciation deductions by taxing that amount as income, typically at a rate of 25%. Whatever amount you claimed in depreciation will be taxed up to 25%, with the remaining gain from the sale of the property being taxed at the capital gains rate.
If your rental property is being used for business purposes, you may qualify for the Section 179 Deduction. Your property must be acquired for business use, must have been acquired by purchase, and cannot be for land or land improvements. This qualification allows you to deduct the cost of this type of property from your income taxes when it was placed in service. In addition, you could be eligible for a First-Year Depreciation Deduction Bonus. This also has a set of requirements that would be worth looking into if your property is being utilized for business purposes and you’re still in your first year of the property being in service.
Conclusion
Taking advantage of depreciation is a powerful way to save on taxes for rental property owners. Understanding how to determine depreciation on a rental property can be tricky, so working with a professional tax expert or property management company can help ensure compliance and that you’re taking advantage of every opportunity. Quartermaster Properties is a veteran-owned property management team offering expert guidance on rental property tax strategies, and we’d love to work with you! Reach out to our team to start the conversation and learn more.
