Owning a rental property provides more than an income stream. It also allows you to save money on your federal income taxes by taking depreciation. Essentially, the United States government lets you operate under the assumption that your asset loses value each year, whether it actually does or not.
It’s a powerful benefit of owning a rental property, but to maximize the benefits you get from depreciation, you have to understand how it works. That sounds like it would be easy, but is anything involving the Internal Revenue Service (IRS) ever truly easy?
How do you calculate depreciation?
Depreciation allows you to spread the tax benefit of qualifying expenses over the lifetime of whatever improvement you’ve made. When you file your taxes, rent and expenses get entered on a Schedule E form. If you had a gain or a loss, that gets carried over to your 1040.
Many expenses are of the single-year variety. An expense like snow removal or power washing the property counts as a single-year expense and you record the full value at one time.
In contrast, redoing your bathroom or putting in new floors count as expenses that can be depreciated. That means if your new bathroom costs $30,000 (it’s a really nice bathroom) and it has an expected lifespan of 15 years, then you can take $2,000 per year as an expense.
It’s a simple math problem to calculate depreciation. You take the value of the item (or the property itself as you will learn below) and divide its value by the number of years in its reasonable lifespan. Then you have the amount you can write off on your taxes as an expense each year.
When it comes to rental property, the biggest asset is the house, condo, or townhome itself. You can take depreciation on your rental property and there’s a formula for that too.
First, you need to determine the value of your property. And to make things more complicated, you have to separate out the value of building from the value of the land. You can depreciate the home, since it, in theory, has a value that gets used up over time, but you can’t take depreciation on the value of the land (since even if the house crumbles, the land will still be there).
Determining value can be done a number of different ways. You can use an appraisal, an insurance agent’s estimate, or a tax assessor’s report to set the value of your rental property. Those numbers may not be the same, but all of them are considered viable when determining your property’s value for depreciation purposes.
When it comes to a property, the IRS has set 27.5 years of useful life as the depreciation period for residential real estate. That means if you have a property worth $200,000 you can deduct $7,272.72 per year as an expense.
You can take depreciation on anything that contributes to the long-term value of your rental property. Fixing a sink that’s clogged, for example, is an expense that must be fully deducted in the year it happens. Replacing the sink, however, counts as a longer-term improvement and it can be depreciated over the life of the sink.
How does depreciation work?
There are some IRS rules around depreciation that you have to follow. Most are obvious, but it’s important to know what they are:
- You have to own the property: It’s okay to have a mortgage but your name (or a business entity you own) must be on the deed to the property.
- It has to be a business: You can’t depreciate a property you mostly use for personal use.
- It has to have a determinable life span.
- The item being depreciated has to have an expected lifespan of longer than one year.
- Furniture cannot be depreciated.
As noted above, you can’t depreciate land, but you can depreciate certain costs associated with the land. The IRS gives this example on its website.
You built a new house to use as a rental and paid for grading, clearing, seeding, and planting bushes and trees. Some of the bushes and trees were planted right next to the house, while others were planted around the outer border of the lot. If you replace the house, you would have to destroy the bushes and trees right next to it. These bushes and trees are closely associated with the house, so they have a determinable useful life. Therefore, you can depreciate them.
You can take depreciation on a rental property or improvements to said property in the year it’s available to go into service. There are multiple examples of this covered by the IRS.
- If you buy a new dishwasher on Dec. 18 but don’t install it until Jan. 3, you can’t start depreciating it until after it has been installed.
- When you buy a rental property and renovate it, you can begin taking deprecation in the year in which you make the property available to be rented (not when you actually start renting it out.)
You can also continue to take depreciation when a rental property is idle. That means it was in use but a tenant moves out and there’s a period where it’s not available to be rented while you make repairs.
Why is depreciation important?
Calculating depreciation on a rental property isn’t hard, but there are lots of quirks to it. There are official IRS guidelines for the lifespans of various items. Appliances, for example, fall into the five-year class while a fence can be depreciated over 15 years.
Even though it can take a bit of work to figure out the value of each item and improvement so you can calculate depreciation on a rental property, it’s still worth doing. And it's very important to make sure you don’t leave any applicable expenses out of your equation.
Doing that would literally be giving money to the IRS when you don’t have to. Ultimately, a little sleuthing along with some good record keeping should more than pay off as you properly calculate the depreciation for your rental property.