When it comes to running a property rental business, taxes may seem burdensome. Fortunately, you can save a lot of money by knowing how deductions work.
One of the most advantageous tax deductions for landlords is depreciation.
But what exactly is depreciation, and how does it work? This article has the answers.
Buildings and other properties are bound to wear out over time and lose value. Depreciation exists to counteract this cost. As one of the most valuable tax rental property deductions for landlords, depreciation, if applied correctly, can save you a lot of money on taxes year after year.
As opposed to operating expenses, which are deducted in the year of usage, depreciation is repeating. Your property is an investment that’s made to last over an extended period, so you can reap the benefits of depreciation for decades.
While depreciation is relatively straightforward, it can get a bit complicated in the details.
Unlike most deductions, depreciation isn’t optional. If you have a property that qualifies (while also not qualifying for one of the three safe harbors), then it must be depreciated in accordance with the IRS’s guidelines.
Here are the four components needed to qualify:
- It must be a long-term property. The asset must be part of your capital investment, meaning it must last longer than a year. Buildings, cars, refrigerators, lawnmowers, etc. all last longer than a year and are therefore depreciable. Fuel and cleaning supplies, on the other hand, are examples of non-depreciable property, and they’re instead categorized as operating expenses.
- The property must decay or get used up. Buildings, mobile homes, swimming pools, appliances, and carpets are examples of depreciable assets because they have a finite lifespan and are subject to wear and tear. Land and stocks, on the other hand, don’t wear out and therefore wouldn’t qualify.
- You must own the property for over one year. Whether you borrowed money to purchase the property is irrelevant. As long as you’ve had the title for over a year, you get the depreciation.
- It must be used for rental activity. If the property is used for personal reasons, it doesn’t qualify. If the property is used for both rental and personal purposes, then you must only depreciate the percentage of the property that applies to your rental business.
How Depreciation Works
To understand how depreciation works, you need to know the four factors that play into it:
- Starting and ending points: You must figure out when your depreciation begins and ends. It’s important to note that depreciation starts when a property is prepared and available to rent, not when it’s purchased.
- Your property’s basis: This is the amount of your total investment in the property for tax purposes.
- Recovery period: This is different depending on the kind of property. The recovery period for residential property is 27.5 years, while it’s 39 years for commercial property. This recovery period has nothing to do with the actual age of the property. It starts/resets with your first year of renting the property.
- Deduction amount: This is a fixed percentage of your property’s basis that will be deducted every year as part of a rental property depreciation schedule.
Once you’ve figured these components out, you can pinpoint depreciation.
Here’s an example: Your property has a depreciable value of $200,000 (the basis). You divide this by 27.5 (the recovery period), which leaves you with an annual depreciation deduction amount of $7,272.
Depreciation is meant to offset the loss in value that a property undergoes over the years. The fact of the matter, though, is that many properties increase in value over time.
While depreciation still lowers your taxes, if the property’s value increases, the IRS will recapture the taxes you avoid through depreciation when you sell your property. This is called rental property “depreciation recapture.”
On the one hand, recapture is good for you in the near future since it gives you more access to capital. On the other hand, it ensures that you’ll pay a higher tax later when it comes time to sell the property.
There are a lot of ins and outs when it comes to depreciation. Understanding what depreciation is, what qualifies as depreciation, and how depreciation works will enable you to save tons of money come tax season.