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How do I compute depreciation on a rental property? Thumbnail

How do I compute depreciation on a rental property?

Key Takeaways

  • Rental property owners use depreciation to deduct the purchase price and improvement costs from your tax returns.
  • Depreciation commences as soon as the property is placed in service or available to use as a rental.
  • Most U.S. residential rental property is depreciated at a rate of 3.636% each year for 27.5 years.

The definition of depreciation is “A reduction in the value of an asset with the passage of time, due in particular to wear and tear”.  It is an accounting concept that allocates some portion of the asset cost to the profit and loss statement during a financial year over the asset’s useful life.  The useful life is defined by the IRS.  Depreciation occurs on most tangible assets, which includes computers, buildings, office equipment, plants and machinery, and much more.  One asset that generally never depreciates is land.   

Residential rental property depreciation is a capital expense, meaning it helps recover the costs you spend to acquire and improve your rental property.  It begins the day you put the property in service.  Depreciation of additional improvements occurs in addition to the depreciation of the original property purchase, but items that are considered “normal wear and tear” are expensed not depreciated.  An expensed item is one that the whole amount of the expense is taken in the year it occurs.  Depreciation expense is generally the largest expense of a residential rental property’s schedule E.  

What property is Depreciable?

The IRS determines what types of properties you can claim depreciation on. For instance, land, landscaping, and a primary residence are not depreciable. For real estate depreciation to be applicable, you can’t place a property in service and sell it the same year you depreciate it. This means that you can’t rent out a property in January, sell it in April and claim depreciation on it that same year.

Properties that fall into at least one of the following categories are typically depreciable:

  • A rental property placed in service after 1986, which means it was used as a rental property after 1986
  • An income-producing property that is expected to last more than one year, which is generally true of all rental properties
  • Residential real estate used to produce income
  • Owner-occupied commercial real estate like a building where you operate your business
  • Income-producing commercial real estate like an office building or shopping center
  • Multifamily properties like buildings with two or more separate units such as a duplex or triplex

How do I compute rental depreciation?

The first step in computing depreciation is to determine the adjusted basis of the asset.  A lot of people assume the adjusted basis of a property is what you paid for the property, while that is generally close it is not correct.  The formula for computing the adjusted basis in a rental property is below;

Adjusted Basis=The original purchase price – the cost of the land – casualty and theft losses deduction taken +/- miscellaneous costs to get it ready to rent  

The miscellaneous costs either adjust the basis up or down depending on what they are.  

Adjust Up:

  • Acquisition costs (i.e., title-related, transfer fees, surveys).
  • Cost for additions or improvements.
  • Cost of installing utility service.
  • Property-related legal fees.
  • Restoration cost related to damage or loss due to theft, flood, fire, or other casualties.
  • Home energy improvement tax credits received after 2005.

Adjust Down:

  • Depreciation (i.e., home used as rental or business).
  • Insurance payouts related to casualty or theft loss.
  • Deductible for casualty loss that wasn’t covered by insurance.
  • Gain on sales of a home before May 7, 1997.

The following items are generally included as closing costs and do not affect the basis;

  • Appraisal fees
  • Pest inspection fees
  • Credit report fees
  • Mortgage broker's commissions
  • Loan fees (not points)
  • Money received for granting an easement.

The tax basis of a rental property is the value of the property that is used to calculate your depreciation deduction on your federal income taxes. The Internal Revenue Service (IRS) defines the tax basis of a rental property as the lower of fair market value or the adjusted basis of the property. The fair market value of the property is the value on the day the property is purchased, if purchased as a rental or on the date of conversion if the property is converted from a personal property to a rental property.  The IRS mandates that costs and depreciation deductions be spread out over 27.5 years for residential properties and 39 years for commercial properties.  The formula for depreciation is as follows;

Annual Depreciation=tax basis of the asset / 27.5 yrs

The following is an example to illustrate the steps of computing depreciation.  

Facts;

  • On January 1st you buy a property for rental costing $100,000
  • The land is valued at $20,000
  • You pay approximately $5,000 of miscellaneous costs.

1) Your first step is to apply the formula for adjusted basis.

Adjusted Basis=The original purchase price – the cost of the land – casualty and theft losses deduction taken +/- miscellaneous costs to get it ready to rent  

Adjusted Basis=$100,000-$20,000-$5,000

Adjusted Basis=$75,000

2) Second step is to compare the adjusted basis to the market value.

Market value=$100,000

Adjusted Basis=$75,00

Lesser of the two or $75,000 equals your tax basis

3) The third step is to divide the tax basis by the useful life.

$75,000 / 27.5=$2,727.00

Annual depreciation=$2,727.00

The bottom line

Investing in rental property can prove to be a smart financial move. For starters, a rental property can provide a steady source of income while you build equity in the property as it (ideally) appreciates over time. There are also several tax benefits. You can often deduct your rental expenses from any rental income you earn, thereby lowering your overall tax liability.  Real estate depreciation is an important tool for rental property owners. It allows you to deduct the costs from your taxes of buying and improving a property over its useful life, and thus lowers your taxable income in the process. Because rental property tax laws are complicated and change periodically, it’s always recommended that you work with a qualified tax accountant when establishing, operating, and selling your rental property business. That way, you can be sure to receive the most favorable tax treatment and avoid any surprises at tax time.