People often associate depreciation with the inevitable wear and tear of a rental property; however, this theory could not be further from the truth. Depreciation is the allocation of property costs – and isn’t necessarily assessing the actual value. Landlords and entrepreneurs will depreciate rental property, even if the house or building is in perfect shape.
The idea behind rental property depreciation is taking a smaller deduction over the course of many years, versus taking one large tax deduction in one year. Property owners would not only depreciate the cost of the rental property purchase, but also the money spent to improve the property is depreciated as well. Basically, any improvement that raises the value of the property, restores the property to new or like-new condition, or creates a new use for the real estate is considered to be a depreciating improvement. Routine repairs and maintenance are not classified within the depreciating improvement category. One-year expenses, that don’t count, can include: gardening, general maintenance, general repairs and Home Owner Association (HOA) fees.
Some common examples of depreciating improvements are: building new additions or garages, installing new systems, such as heating or air conditioning, replacing the roof, adding wall-to-wall carpeting, and installing accessibility upgrades, such as a ramp for the disabled.
The International Revenue Service (IRS) has developed a criteria list that defines what exactly a depreciable property is:
- The individual must own the property. It cannot be rented or borrowed from someone else.
- The property must produce income. This can be a rental or a renovated building used for a production business.
- The property must be defined as “useful life.” This means the property must be worn out at some point. For example, a house is considered to have a useful life, but a piece of land does not.
- The useful life term must be longer than one year.
The concept behind “useful life” can be confusing; however, the IRS deems a residential property to have a life span of approximately 27.5 years, whereas a new water heater will have a useful life of only five years. However, the savings on your taxes can be substantial – especially because you can prolong the deductions for several years.
One of the biggest misunderstandings about qualifying for depreciation deductions is knowing when you can begin claiming the deduction. This is one of the biggest misunderstood concepts related to rental property depreciation. The answer is you can begin taking depreciation deductions when the property generates rental income – the IRS refers to this as putting the property “in service.”
Another confusing element within depreciation deductions is the legal timeframe of how long you can claim it. Ultimately, one of these two ordeals must happen:
- You can only deduct until the cost basis of what you acquired the property for is met. This does include certain taxes, fees paid at settlement and any improvements to the property.
- You stop generating income from the property. This means you would have either sold the property or decided to stop renting the property out.
Calculating depreciation can be somewhat confusing. Realtor.com provides a great “straight-line method.” For the most part, this method is used for home improvements. Their step-by-step directions include:
First, deduct the estimated salvage value from the original cost and divide by the useful life of the asset. The example that Realtor.com uses is the purchase of a new dishwasher for $600. The appliance has an “estimated useful life” of five years, and would be worth $100 at resale at the end of the five years, then the annual depreciation using the straight-line method would be as follows:
(Cost of asset - salvage value)/estimated useful life = annual depreciation expense
($600 - $100)/5 = $100 in annual depreciation expenses
As for the residence itself, the IRS requires you to calculate depreciation over its 27.5 useful years using a different method called the modified accelerated cost recovery system. The math is a bit complex, but to get a ballpark of your expenses you can enter the cost of your property and other variables into a property depreciation calculator at Calculator Soup. Theoretically, buildings lose value as they age and that is how the IRS determined the deduction rate of 1/27.5th of the property’s cost each year.
Nonetheless, rental home investing is an extremely popular method for new investors or others who want a reliable monthly cash flow, rather than being dependent on large short-term profits. There is no doubt that rental property investing will always be a great investment since the real estate market continues to do well and there will always be tenants looking for rental properties.