Rental property depreciation is an accounting principle that helps real estate owners reduce their taxable income and income tax bill. Determining property depreciation and understanding the various calculation factors are necessary for those looking to offset taxable income.
What Is Rental Property Depreciation?
Rental property depreciation is a method for deducting the cost of a large asset over its useful life. Instead of one large deduction in the year the property is purchased, depreciation is distributed across its useful life. You can depreciate your rental property if:
- You are the property owner.
- The property is used for investment or business purposes.
- Its useful life is one year or longer.
This concept is in place due to the Internal Revenue Service (IRS) tax rules. Though purchasing a rental property costs a large sum, the IRS prevents property owners from taking a substantial amount of tax deductions at once. However, property is a tangible asset that depreciates during its lifetime. Depreciation deducts the costs property owners must invest to purchase and upkeep the property.
When Does Property Depreciation Begin?
Property depreciation starts when the property becomes available to rent or is placed in commercial use. The recovery period is the time property owners can take depreciation, and it ends either when the property is sold to another party or the total cost basis is fully depreciated.
Property owners must understand how to depreciate rental property before calculating the cost of depreciation. A rental property that was placed in service and disposed of or no longer used for business purposes in the same year cannot be depreciated. This factor is true even if the property meets the IRS requirements of a depreciable asset.
How to Calculate Depreciation on Rental Property
You can calculate your annual depreciation amount based on the cost basis and value of the property, the length of the recovery period, and the depreciation method used.
The cost basis is the property’s capital expense minus the land value. The capital expense includes seller debts the buyer agreed to pay and recording, abstract, and legal fees. The costs of property improvements must be added in the year they were incurred.
For the recovery period, we must consider how long the property has been determined to last. Rather than deducting the actual costs incurred by wear and tear on the property each year, deductions are averaged over the valuable life of the property. Most commercial real estate improvements are presumed to last 39 years, while residential property improvements are presumed to last 27.5 years.
The depreciation methodology for residential buildings for U.S. tax purposes is the Modified Accelerated Cost Recovery System (MACRS). Most rental property owners calculate property depreciation using the General Depreciation System (GDS), though the Alternative Depreciation System (ADS) can be used in some circumstances.
The Cost Basis
The Cost Basis
Depreciation considers the cost basis of the depreciation-eligible portion of the property and divides that amount by the established valuable life span of the property to determine the annual deductible amount.
- Therefore, if improvements of a standard commercial property have a cost basis of $200,000 at the time the property is placed into service, then the $200,000 cost basis is divided by 39 years, resulting in a depreciation deduction of $5,128 annually until the investor has recovered their cost or retires the property from service.
- The investor of a residential property with the same cost basis, alternatively, could deduct $7,272 annually. Residential rental property typically depreciates over 27.5 years at 3.636% per year.
- Your deduction amount may differ for the first year if the property was not in service the entire year and may change in later years if a significant change in cost basis or life span occurs.
Depreciation After a 1031 Exchange
There are two types of depreciation after a 1031 exchange:
- Single schedule depreciation, which is the new adjusted cost basis of the asset divided by 27.5 years to calculate the annual depreciation.
- Two schedule depreciation, which is the adjusted cost basis for the property sold divided by 24.5 years (first schedule) and the remaining cost basis of the replacement property divided by 27.5 years (second schedule).
Two schedule depreciation is the preferred tax code method, though single schedule depreciation is more straightforward.
A 1031 exchange allows you to defer taxes owed for depreciation recapture. Under standard circumstances, after a 1031 exchange, your annual depreciation amount remains the same for your replacement property as it was for your relinquished property.
Regardless of market value, your new property’s cost basis is equal to that of the old property and the useful life term continues from where you left off with the old property. Therefore, if you had depreciated your relinquished property for 10 of 39 years, you have another 29 years of eligible depreciation for your replacement property.
The Depreciation Calculation
Now, it’s not always that easy because it’s possible you’ve exchanged your previous property with a different type of property that requires a depreciation calculation based on a different life span or convention of calculation.
In this case, the IRS requires you to use the calculation method that results in the least amount of depreciation.
Another benefit to a 1031 exchange is that deferred depreciation, like deferred capital gain, is eliminated at the time your investment property is transferred to your heirs when you continue the cycle of exchanging throughout your lifetime. Because heirs inherit property at the current market value, they receive a step-up in cost basis, and the accumulated depreciation is no longer relevant.
Contact 1031 Crowdfunding to Learn More About Property Depreciation
Rental property depreciation can help you reduce your taxable income, increase your income, and improve your financial portfolio. 1031 Crowdfunding assists rental property owners with calculating property depreciation or deferring taxes through a 1031 exchange. Contact us or read our blog for more information about property depreciation.
This material does not constitute an offer to sell or a solicitation of an offer to buy any security. An offer can only be made by a prospectus that contains more complete information on risks, management fees and other expenses. This literature must be accompanied by, and read in conjunction with, a prospectus or private placement memorandum to fully understand the implications and risks of the offering of securities to which it relates. As with all investing, investing in private placements is speculative in nature and involves a degree of risk, including loss of your principal. Past performance is not necessarily indicative of future results and forward-looking statements and projections are not guaranteed to achieve the results described and your actual returns may vary significantly. Investments in private placements are illiquid in nature and there may be no secondary market or ability to sell the investment should the need for liquidity arise. This material should not be construed as tax advice and you should consult with your tax advisor as individual tax situations will vary. Securities offered through Capulent, LLC Member FINRA, SIPC.
