Rental Property Depreciation Rules For Investors
Investing in real estate is beneficial for investors in many ways. Unlike other investment types, such as stocks or bonds, for instance, real estate investments are far less risky and there are also various tax benefits to be considered as well.
This is especially true for rental property investments. When it comes to tax advantages, rental properties allow you to earn a steady rental income but you can also lower your tax liability by deducting taxes from any rental income you earn.
Rental expenses such as mortgage, insurance, property tax, repairs, maintenance and so on can be deducted in the year you spend the money on these things. However, there is also the depreciation tax deduction that works a bit differently than other tax benefits.
With that in mind, here are a few rental property depreciation rules that all investors should know.
What is depreciation?
Before we proceed with the rules, let’s take a moment to explain what depreciation really is. Simply put, depreciation is a process that allows tax deductions of the costs of buying or improving a rental property.
Therefore, instead of taking a single large deduction in the year you have purchased a rental property, your taxes are deducted or distributed over the useful life of a property. In the U.S., the IRS (The Internal Revenue Service), is responsible for assigning depreciation rules so it’s important to familiarize yourself with these rules. Here are some of the important rules you should know.
Determine Which Property is Eligible for Depreciation
To determine whether or not your property is eligible for the depreciation tax deduction, you must first determine if it meets the necessary criteria or requirements imposed by your government. For example, here are a few requirements for a rental property to be depreciated.
- You must be the owner of the property.
- The property is used to generate income.
- The property must have a useful life, i.e., its value diminishes over time due to decay and wearing out due to natural causes.
- Your property is expected to last more than a year.
Determine how much you can deduct
Now comes the tricky part. Determining just how much you can deduct from your rental property via depreciation can be a challenge, especially for investors that are new to the whole concept. In that case, it’s advisable to consult with professionals who can provide you with an accurate depreciation estimate.
That said, the amount that can be deducted comes down to local rules, tax laws and regulations. However, here are a few common factors that can help you calculate depreciation.
- The property basis – This means the cost of buying a rental property with cash, mortgage or some other means. The basis also includes legal fees, transfer taxes, recording fees and similar expenses.
- Land and building cost separation – Only the value of the building can be depreciated, not the land the building is on, which is why you must separate the costs and determine only the value of the building from the full price of the both you paid for.
- Calculate the adjusted basis – After purchasing the rental property, you might have to take some time to get it ready for renting out. The money you’ve spent on renovations and repairs is considered the adjusted basis which should be added to the property basis once your property is ready for service.
Understand When the Depreciation Ends
Although beneficial, depreciation doesn’t last forever, unfortunately. Understanding when it ends helps you avoid misunderstandings and inconveniences. Again, the rules regarding the end of depreciation depend on specific rules in your country but here are some of the common circumstances that will end property depreciation.
- You deducted the entire cost or basis of the property.
- You decide to retire the property from the rental service.
- You sell the property or convert it.
Depreciation tax deduction makes rental properties more interesting to investors. However, for you to fully benefit from this tax advantage, you must first understand all the rules that are involved.
If you are planning to purchase a rental property, speak to an accountant about how to manage depreciation. This should be done before making a purchase. Depreciating the property effectively can provide you with significant tax relief and it is something that seasoned real estate investors take full advantage of.
Advice for First Time Landlords – read about what to expect when purchasing your first rental property.
Fix and Flip Lenders – See how to finance fix and flip real estate projects.