March 1, 2013

How Rental Property Depreciation Works

One of the big tax benefits of owning rental real estate is the ability to claim depreciation of the property as a tax deduction.  This can result in a pretty substantial tax deduction.  

What is depreciation?    

First lets explain what depreciation means.   Depreciation is simply used to account for the loss of value in an asset over time.   Its easier to think of something like a car or a washing machine which will wear out over time and has a limited lifespan.   Its pretty clear that a car will generally lose value over time so a 10 year old car is worth a lot less than a 1 year old car.   For accounting purposes you can write this off as a cost to your business.  With equipment that has more than 1 year lifespan they use depreciation to write off the cost of the equipment over a longer period.   The depreciation period can vary depending on the kind of equipment.    Real property like a residential rental will also depreciate over time.  Buildings wear out over time just like anything else.   Now this seems upside down because generally the market value of real estate appreciates over time.  

What do you depreciate?

For depreciation of residential real estate you use the cost basis of the property excluding the value of the land.   You do not depreciate land value.   You can only depreciate the value of the buildings.   In addition to depreciating the building itself you can also depreciation certain types of equipment and capital improvements for a rental.  If you add an addition to a rental then you would depreciate the value of the addition as well.   Some things like appliances are also depreciated but they use a different depreciation schedule and I'll keep the discussion to the depreciation of the buildings for now.

How do you Determine the Value of the Land?

Figuring exactly how much the building is worth versus the land may not be straight forward.   When you buy a rental you buy the building and land together so you don't necessarily see a value for the land.   

Appraisals - This is probably the best way to get a value for land.  If you get an appraisal then you should have a value in the appraisal to show the value of the land. 
Property Taxes - A property tax statement may break down the value of the land versus the value of the building.    Property taxes work in a variety of ways and are often not a realistic reflection of actual market values.   However if your property taxes do break down land versus property then you can use that amount or ratio as the basis for figuring the value of the land when counting deprecation on your federal taxes.
Comps - Lastly you could look at the value of a vacant lot of similar size and estimate the value of land in the area.  For example if your rental house sits on 1/4 acre and an empty 1/4 acre lot in your area sells for $20,000 then you could use that comp to estimate the value of your land at $20,000.

How do You Calculate Depreciation?

Residential rental property is depreciated over a 27.5 year period.   That means that every year you depreciate 1 / 27.5 of the initial property value in a proportional straight line method.  So for example if you bought a house worth $100,000 and figured the land is worth $10,000 then the building is worth $90,000.   You then depreciate 1/27.5 (or 3.636% ) of that amount each year until 27.5 years are up and you've fully depreciated the property.  That would give you a deduction of 90,000 / 27.5 = $3,272.72 per year.    You would then depreciate $3272 per year every year that you own the property until you've done so for 27.5 years.

Theres is a catch..  You have to Pay it back when you sell.

Depreciation is a hefty deduction on your rental income but its not really a free ride.   When you sell a rental property you will generally have to pay back the depreciation in the form of depreciation recapture.    Recapture is a tax on the depreciation you claimed that you then get back in a sale.   Lets say you buy a house for $80,000 and then depreciate it about $14,500 over a few years.    You then sell the house for $100,000.   You'd have to pay capital gains on the $20,000 increase in value plus you'd have to pay depreciation recapture taxes on the $14,500 that you claimed in depreciation.

Summary points :
1. Depreciation of rental property is a tax deduction that offsets your rental income.
2. The amount you depreciate is the purchase price minus the value of the land. 
3. Calculating deprecation is = 3.636% x (property - land)
4. You depreciate the property in equal amounts annually for 27.5 years
5. If you sell the property you do have to repay depreciation recapture taxes.


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4 comments:

  1. If you have to pay it back, what's the point? It seems like just an interest-free loan from the IRS.

    Can you avoid the recapture by living in the building for 2 years before you sell it?

    ReplyDelete
  2. SteveD,

    Simply deferring the tax bill is a benefit in itself. That lets you grow the asset over time and avoid paying the taxes potentially for decades. The impact of inflation makes it beneficial to defer as well. Would you rather pay a $1000 tax bill today or 30 years from now? If you're in a higher income tax bracket then you can also potentially you can avoid a higher income tax rate and later pay a lower recapture rate.

    And you also don't have to pay recapture until you sell.

    You can swap properties with a 1031 exchange and avoid paying the taxes.
    If you pass the asset to your heirs then they won't incur a tax bill.

    Looks like you can't get around recapture by converting to a primary residence. A least not for depreciation after the 1997 law.

    I see multiple references on this. Here's one...

    http://taxes.about.com/b/2006/01/26/tax-impact-of-selling-a-home.htm
    "You cannot exclude from taxation any gains which are attributed to the depreciation you claimed after May 6, 1997. "

    Jim

    ReplyDelete
  3. I'm glad you mentioned the catch! the Capital gains tax when you sell is probably one of the most overlooked aspects of investment real estate. I'm curious if you can get away from that by putting in a trust that's part of your estate, or just making it a part of your estate to pass on? Of course you wouldn't be able to sell it during your lifetime but it would probably keep any gains out of the tax mans hands.

    ReplyDelete
  4. Jose,

    Most people can avoid paying taxes on appreciated real estate by leaving it to heirs. However the estate may have to pay estate taxes on the first $5 million. Course most people don't have that much. Say you've got $500,000 worth of property and you leave it to your kids. The estate isn't large enough for estate taxes and the kids get the property at a cost basis of $500,000 so they don't have to pay capital gains. Its effectively tax free inheritance.

    Jim

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