You might know that your rental property depreciates over time. Even if you understand the concept, you might not know the specifics of depreciation on your tax return. How does depreciation work?
The tax code is long and complex, so you might leave it to your accountant or tax preparation software. However, if you do this, you might miss out on some worthwhile deductions that could have saved you hundreds of dollars.
Depreciation is just one concept in rental property taxes you should know before you file with the IRS. By taking the time to learn about it, you can not only save money but also reduce your chances of being audited.
Here are the basics of depreciation for rental property.
What is Depreciation?
Before diving into the specifics of depreciation for landlords, it’s important to understand the basic concept.
As you know, you pay taxes on your rental income each year. Let’s say your rental business makes $97,000 this year. Is that the amount that should be taxed?
Not quite. Your rental business doesn’t just make money; it also loses some due to maintenance expenses, evictions, contracted work, employee compensation, etc. It wouldn’t make sense to tax the entire $97,000 because you spent some of that income to run your business.
The point of deductions and depreciation is to subtract those expenses from your taxable income so that you only pay taxes on your net gain.
Depreciation is an annual tax deduction you take on long-term property—that is, property that constitutes a capital investment (not ordinary operating expenses but long-term investments). You deduct a portion of the expense every year until it’s fully deducted to reflect the property’s decline in value as it gets worn out.
When is Depreciation Applied?
Depreciation applies to a variety of different types of property: buildings, land improvements, computers, cars, equipment, and more. Land itself cannot be depreciated because it theoretically does not wear out over time.
The IRS generally uses four criteria to determine whether property should be depreciated:
- Long-Term Property – It has a useful life greater than one year.
- Subject to Wear and Tear – It wears out or declines in value over time.
- One Year Minimum Ownership – The title to the property has been in your name for at least a year.
- Rental Use – You use it for rental activities, not personal ones.
Unlike most deductions, depreciation isn’t optional. This means if you have property that qualifies, the IRS will treat it as depreciated automatically.
So how does depreciation work? The two biggest concepts to understand are recovery periods and recapture.
The recovery period is the length of time that property is depreciated. Real residential property has a recovery period of 27.5 years. For example, if you own several buildings with rental units, each building gets depreciated over 27.5 years (even if they appreciate over time).
Other kinds of property have shorter recovery periods. For personal property you use in your rental business (furniture, computers, cars), recovery periods can be as short as five to six years. However, personal property can usually be fully deducted using an exception provided by the Tax Cuts and Jobs Act (TCJA) called bonus depreciation.
Recapture is the term used for the tax you’ll eventually pay on the depreciation deductions when you sell the property. Unlike regular deductions, which never return, depreciation amounts return when you sell. This amount is taxed at the recapture rate (25%), which is slightly higher than the typical capital gain rate.
To calculate depreciation, you’ll need to know three pieces of information.
The cost basis is the amount the property is worth for tax purposes. Most of the time, you can use the original purchase price (or equivalent fair market value) as the cost basis.
You’ll also need the recovery period, which is listed in the tax code for different types of property.
Lastly, figure out the percentage of the cost basis you’ll deduct each year based on the cost basis and recovery period. For straight-line depreciation (the simplest method of depreciation), this percentage is just 1 divided by the recovery period.
Understanding Tax Basics for Rental Success
Depreciation is not an easy concept to understand. Beyond the summary provided here, there are many details, exceptions, and stipulations in the tax code. While you can certainly read through it, it’s okay to leave the fine print for an accountant or software. Your goal should be to understand the basics and how they affect your business.
You won’t regret dedicating your time to learning about depreciation and other tax basics. With the help of professional property management software or other tools, you can leverage your new knowledge to make tax season the least stressful as possible.