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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