How to Figure Depreciation on Rental Property: A Landlord’s Guide to Tax Savings

Depreciation on a rental property allows you to deduct a portion of the property’s cost each year over its useful life, effectively reducing your taxable income. To figure depreciation, you need to determine the property’s basis, subtract the land value, and then divide the remaining depreciable basis by the recovery period (usually 27.5 years for residential rental properties). This annual depreciation expense can significantly lower your tax liability, making it a crucial component of successful rental property management.

Understanding Depreciation: The Cornerstone of Rental Property Tax Savings

Depreciation, in the context of rental property, isn’t about your property literally losing value. It’s a tax deduction that acknowledges the gradual wearing down of your investment over time. Think of it as Uncle Sam giving you a pat on the back (and a tax break) for providing housing! Effectively leveraging depreciation is crucial for maximizing your returns and minimizing your tax burden as a landlord.

Step 1: Determining Your Property’s Basis

The basis is essentially the starting point for calculating depreciation. It’s what you initially paid for the property, plus certain additional costs. Here’s how to calculate it:

• Purchase Price: The price you paid for the property.
• Closing Costs: Expenses incurred during the purchase, such as legal fees, recording fees, survey fees, and transfer taxes.
• Capital Improvements: Permanent improvements made after the purchase that add value to the property or extend its useful life. Examples include adding a new bathroom, replacing the roof, or installing central air conditioning. Note: These are separate from repairs, which maintain the property’s current condition.
• Deduct any rebates or settlements: If you received any rebates or financial settlements during the purchase, those should be deducted from the basis.

Example: You purchase a rental property for $200,000. Your closing costs are $5,000. Six months later, you add a new deck for $10,000. Your initial basis is $200,000 + $5,000 + $10,000 = $215,000.

Step 2: Separating Land Value from Depreciable Basis

Here’s the kicker: land is never depreciated. The IRS considers land to have an unlimited lifespan. So, you need to separate the land value from the total basis.

• How to Determine Land Value: The most common methods are:

  • Property Tax Assessment: Your local tax assessor’s office often lists the assessed value of the land separately from the building. This is a readily available and generally acceptable estimate.
  • Appraisal: If you recently had an appraisal done, it should include a separate valuation for the land.
  • Percentage Allocation: If neither of the above is available, you can estimate the land value based on the relative value of comparable properties in the area. For instance, if land values are typically 20% of the total property value in your area, you can use that percentage.

Example (Continuing from Above): The tax assessor’s office values the land at $40,000. Therefore, your depreciable basis is $215,000 (total basis) – $40,000 (land value) = $175,000.

Step 3: Calculating Annual Depreciation

Now for the main event! You’ll use the Modified Accelerated Cost Recovery System (MACRS), which is the IRS’s method for depreciating assets. For residential rental property, the recovery period is 27.5 years.

• Straight-Line Depreciation: This is the most common method for rental properties. It’s simple:

  • Annual Depreciation Expense = Depreciable Basis / Recovery Period

Example (Continuing from Above): Your annual depreciation expense is $175,000 (depreciable basis) / 27.5 years = $6,363.64. You can deduct $6,363.64 each year for 27.5 years.

Step 4: Special Considerations – Partial Year Depreciation

The above calculation assumes you owned the property for the entire year. What if you only owned it for part of the year?

• Partial Year Depreciation: You can only depreciate the portion of the year the property was available for rent.

Example (Continuing from Above): You purchased the property on July 1st. You only owned it for 6 months (half a year). Your depreciation expense for that first year would be $6,363.64 / 2 = $3,181.82.

Step 5: Claiming Depreciation on Your Tax Return

You’ll report your depreciation expense on Schedule E (Supplemental Income and Loss) of Form 1040. Be sure to keep accurate records of your property’s basis, land value, and all depreciation calculations. Form 4562 Depreciation and Amortization would be used for the first year and whenever major improvements are made that require re-calculating the depreciation.

Depreciation: It’s Not Just Buildings – Personal Property Too!

Don’t forget about depreciating personal property used in your rental! Things like appliances, furniture, and carpets can also be depreciated, although they have different recovery periods than the building itself (typically 5 or 7 years).

• Recovery Period of Personal Property: Use the IRS guidelines (Publication 946, How to Depreciate Property) to determine the appropriate recovery period for each item.
• Claiming Personal Property Depreciation: Just like with the building, you’ll report this depreciation on Form 4562 and then the total on Schedule E.

FAQs on Depreciation for Rental Properties

1. What is Cost Segregation and how can it help me?

Cost segregation is a specialized engineering-based analysis that identifies building components that can be depreciated over shorter periods than 27.5 years. This can significantly accelerate depreciation deductions, leading to substantial tax savings, especially in the early years of ownership. It is particularly useful for larger properties or substantial renovations.

2. What if I remodel my rental property?

Remodeling projects that are considered capital improvements (adding value or extending the property’s life) are added to the property’s basis and depreciated over 27.5 years. Repairs, on the other hand, are expenses that maintain the property in good working order and can be deducted in the year they are incurred. The line between a repair and an improvement can be tricky, so consult with a tax professional if you are unsure.

3. What is Section 179 deduction, and can I use it on rental property?

Section 179 allows you to deduct the full cost of certain qualifying property in the year it’s placed in service, rather than depreciating it over several years. While generally applicable to businesses, its applicability to rental properties can be limited and dependent on active participation. Consult a tax professional to determine eligibility.

4. What is bonus depreciation, and how does it affect my rental property?

Bonus depreciation allows you to deduct a large percentage of the cost of qualifying property in the year it’s placed in service. Although sometimes used on building improvements that qualify, it is more commonly used for personal property like appliances. Current law allows for 80% bonus deprecation in 2023, phasing down 20% each year.

5. What is accumulated depreciation, and how does it affect the sale of my rental property?

Accumulated depreciation is the total amount of depreciation you’ve claimed on the property over its life. When you sell the property, you may have to recapture some of the depreciation as ordinary income, which is taxed at a higher rate than capital gains. This is known as depreciation recapture.

6. How does depreciation recapture work when I sell my rental property?

When you sell your rental property for a profit, the IRS “recaptures” the depreciation you previously deducted. This means you have to pay income tax on the amount of depreciation you claimed over the years, up to a maximum of 25% on the accumulated depreciation. This amount will be taxed as ordinary income. The remainder of any profit will be taxed as a capital gain.

7. Can I depreciate a rental property if I don’t have a mortgage?

Yes! The ability to depreciate your rental property is not contingent on having a mortgage. It is based on the property’s basis, land value, and recovery period, regardless of how you financed the purchase.

8. Can I depreciate a property that is not currently rented?

Generally, you can only depreciate a property if it is “held for the production of income.” This means that it must be available for rent and you must be actively trying to rent it. Vacant properties undergoing renovations or actively marketed for rent generally qualify.

9. What happens if I inherit a rental property?

When you inherit a rental property, your basis is generally the fair market value of the property on the date of the deceased’s death. You’ll need to determine the land value at that time and depreciate the remaining basis over 27.5 years.

10. What happens if I convert my personal residence into a rental property?

When you convert your personal residence to a rental, your depreciable basis is the lower of either your adjusted basis or the fair market value of the property on the date of conversion. Then, subtract the value of the land at that time. This becomes your depreciable base.

11. What records do I need to keep for depreciation?

Keep meticulous records including:

• The purchase price
• Closing statements
• Invoices for capital improvements
• Property tax assessments
• Appraisals
• Depreciation schedules (showing annual depreciation claimed)

12. Should I consult with a tax professional regarding depreciation?

Absolutely! Depreciation rules can be complex. Consulting with a qualified tax professional is highly recommended to ensure you are maximizing your deductions and complying with all IRS regulations. They can help you navigate complex scenarios, perform cost segregation studies, and optimize your tax strategy.

By understanding and effectively utilizing depreciation, you can significantly improve the profitability of your rental property investments. Remember to keep detailed records and consult with a tax professional to ensure you are maximizing your tax benefits.