Real estate can be a great passive revenue stream if appropriately managed. But besides the direct income from rents, there’s another lucrative, albeit a bit more complicated benefit of owning a rental property: depreciation.
It’s a little-known perk that could save you considerable money when tax season rolls around. Essentially, you write off a portion of the cost of your property each year, reducing your overall taxable income. But there’s more to it than just that.
What Is Rental Property Depreciation?
When it comes to rental properties, the IRS views things a little differently: “Sure, your property might get a bit older and more worn, but it’s still bringing in income. So, we’re going to let you deduct a portion of the cost of that property from your taxable income each year because we understand it’s gradually ‘wearing out.'”
This is what the IRS refers to as depreciation, and it’s calculated over what they’ve determined to be the “useful life” of a residential rental property — which they’ve set at 27.5 years. So, each year for 27.5 years, you can deduct a portion of the original cost of your rental property plus any improvements you’ve made.
What Property Is Depreciable?
Here’s a checklist of the requirements a property must meet to be considered depreciable:
- You must own the property. However, you can also depreciate any capital improvements for a lease property.
- You must be using the property to generate income.
- The property must have a determinable useful life.
- It must be expected to last for over a year.
There are a few more things to note from the IRS, like section 179 Deductions and other date-specific limits for depreciation. Likewise, when filing, consult your tax professional to ensure you take full advantage of permissible deductions.
Why Depreciate Property?
Here’s why it’s beneficial to depreciate property: it boosts your overall return on investment by reducing your taxable income and the amount of taxes owed.
Now, spice things up with some helpful tools to supercharge your depreciation and your investor returns:
- Cost segregation is a strategic tax planning tool that allows you to increase cash flow by accelerating depreciation deductions and deferring federal and state income taxes.
- Accelerated depreciation lets you deduct more of the property’s cost earlier. This means you get more tax benefits upfront.
These tools are like having a secret weapon in your tax strategy arsenal that significantly improves your bottom line.
What To Know About Depreciation When Selling a Rental Property
Depreciation can complicate things when you decide to sell. The IRS keeps tabs on the depreciation you’ve claimed, and when you sell, because they want some of it back in what’s known as “depreciation recapture.” Plus, if you sell for a profit, you might be subject to capital gains tax, making it crucial to understand these tax implications.
Depreciation Recapture Tax
Depreciation recapture is the IRS’s version of “what goes around, comes around.” During the years you owned your rental property, you could claim depreciation, which lowered your taxable income and taxes. But then, when you sell your property, the IRS steps in and says, “Remember all that depreciation you claimed? We’re going to need some of it back.”
Essentially, it’s the process where the IRS taxes the portion of the gain attributable to the depreciation deductions previously claimed during the years you owned the property. The logic is that since depreciation deductions reduce your ordinary income rate, which is higher, the recaptured amount needs to be taxed when you sell, as it’s considered a gain.
How do taxes work with this? Like your everyday income, the money you get from selling your property for more than its depreciated value is taxed. As of 2022, the highest tax rate you’d pay on this gain for real estate is 25%. To figure this out, look at the difference between the sale price and its adjusted value after depreciation.
Capital Gains Tax
Capital gains tax is a tax you have to pay when you sell something for more money than you originally paid for it.
Consider this example:
- You bought a rental property for $500,000 ten years ago, and sell it for $1,000,000. That $500,000 profit you made is a capital gain subject to tax.
Now, there are two types of capital gains tax:
- Short-term: This applies to assets you’ve owned for a year or less, usually taxed at your regular income tax rate.
- Long-term: If you’ve owned your property for more than a year, you’re looking at a capital gains tax rate of 20%. But the exact rate you pay depends on your income, and tax laws can change.
When you sell your rental property, you’ll need to pay first on the part of your gain due to depreciation.
How To Calculate Depreciation on Rental Property
Calculating depreciation means dividing the property’s cost (minus the value of the land) by its useful life. This gives you a yearly amount to deduct from your taxable income.
But taxes can be as complex with various twists and turns like the Alternative Minimum Tax (AMT), a tax system separate from the regular one designed to prevent taxpayers from paying too little tax.
Determine Cost Basis
Think of cost basis as the starting line for your depreciation race. It’s the original cost of your property, which you’ll gradually “recover” through depreciation over the years. So, how do you calculate it?
- Start with the purchase price of your property.
- Add costs related to the property purchase.
- Include the cost of improvements made to the property with a useful life of more than one year.
- Do not include the value of the land in the cost basis.
- Determine the value of the building separately from the land.
Once you have your cost basis, you can calculate your annual depreciation deduction!
Identify Depreciation Method
There are a few different depreciation systems. Per Publication 946 from the IRS linked above, one of the central systems is called MACRS, which stands for Modified Accelerated Cost Recovery System. It consists of General Depreciation System (GDS) and the Alternative Depreciation System (ADS).
Under MACRS, residential rental property generally depreciates over a recovery period called straight-line depreciation. Meaning you’re deducting the same amount each year over the recovery period. GDS gives you higher depreciation deductions in the earlier years and a lower deduction at the end, while ADS is more spread out over time.
Calculate the Depreciation Expense
Picture this: you bought a residential rental property for $300,000, and the value of the land is $50,000. Remember, you don’t depreciate the land, so subtract that value to find the cost basis — $250,000. Under the GDS, which is the most common for residential rental property, depreciate this over 27.5 years. So, divide $250,000 by 27.5 to get an annual depreciation expense of about $9,091.
Now, fast-forward ten years:
- You’ve been deducting that $9,091 depreciation expense yearly, so you’ve accumulated about $90,910 in depreciation. If you decide to sell for more than the depreciated value, depreciation recapture comes into play.
- Let’s say you sell the property for $350,000. The adjusted cost basis of the property is now $159,090 ($250,000 – $90,910). The gain on the sale is the selling price minus the adjusted cost basis, or $190,910 ($350,000 – $159,090).
- Of this gain, $90,910 is depreciation recapture, subject to a maximum tax rate of 25% for 2022. The remaining money is capital gain.
However, always check with a tax professional to get the right advice first.
Other Ways To Reduce Tax Liability Through Real Estate
Investing in real estate is also about leveraging the tax benefits that tag along:
- If you’re renting out part of your residence, you may be able to claim a personal-residence exemption.
- If your rental property is furnished, or if you’ve equipped it with appliances, you can depreciate these items.
- If you’re paying a property manager or management company to handle day-to-day tasks, those fees can often be deducted.
But what if you’re looking to invest in real estate without the headaches of direct property management? Enter real estate private equity firms. These firms pool funds from multiple investors to invest in real estate. They help simplify tax matters and potentially deliver higher returns, but ensuring they have a proven track record is essential.
Investing through a private equity firm often means receiving a K-1 form at tax time. A K-1 is a tax document that reports your share of the firm’s income, deductions, credits, and other tax items. It’s an essential piece of the tax puzzle when investing in real estate indirectly.
Whether you’re a DIY landlord or an armchair investor, always understand the tax implications of your real estate ventures.