Updated May 10th, 2019
Wondering how to calculate depreciation on a rental property? We’re here to teach you.
Purchasing rental properties is a smart financial move. You can earn a steady source of income from your tenants while also building equity in a property.
There are also pretty sweet tax deductions for landlords meant to stimulate economic growth. The best of these is what is known as depreciation.
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How to Calculate Depreciation on Rental Property
There are very specific rules around depreciation. Here is everything you need to know:
What Is Depreciation?
The depreciation of a rental property is the associated tax breaks for buying a new rental unit. When you purchase or improve a rental property, you don’t just take one big deduction the year you purchase the property.
Instead, the IRS asks that you distribute the deductions throughout the “useful life” of the unit.
What Kinds of Properties Are Depreciable?
In order to meet the requirements for depreciation, a rental property must check all of the following boxes:
- You have to own the property. You are still the owner for tax purposes even if you have a mortgage on the unit.
- You must use the property in a way that generates
- The property must have a set “useful life.” This means that it can decay, get used up, wear out, or lose value from natural causes.
- The property’s “natural life” must last more than a year.
One last thing to keep in mind: you cannot depreciate a property you placed in service (i.e. started using it for income) and disposed of it (i.e. stopped using it for business) within the same calendar year.
Land does not wear out or get used up, so you cannot use the depreciation tax credit for it. You also cannot depreciate the costs of planting, landscaping, or clearing land. This is because these things are all just maintenance costs for a non-depreciable asset.
How Long Do You Account for Depreciation?
The time for how to calculate depreciation on a rental property is pretty straightforward.
The clock for depreciation starts as soon as a property is placed in service. For example:
You bought a fixer-upper on January 1st. On March 31st, you finally finish the repairs and begin advertising for tenants. Even if no one moves in until May 1st, because the house was ready to be occupied in March, that’s the start of the deprecation date.
From that moment, you can continue to depreciate the property until one of the following occurs:
- You deduct the entire cost of property
- You retire the property from service (i.e. you stop using it to make money).
If a property is “idle,” you can still claim a deduction as long as it resumes its business purpose not long after. For example, if you need to repair the foundation or make other repairs in between tenants, you can still claim the deduction.
If you purchased your unit after 1986, a law known as the Modified Accelerated Cost Recovery System governs it. Under this law, you can spread depreciation deductions out over 27.5 years under the main classification system (40 years under the other), which is how long the IRS thinks the “useful life” of a property can be.
What Factors Determine the Depreciation Amount?
There are three main things to consider when calculating the depreciation amount for a rental property.
They are as follows:
The Basis of the Property
Your basis in the property is the purchase price. Typically, you can include things like closing costs, settlement fees, transfer taxes, and title insurance; however, some closing costs like fire insurance, loan refinancing, mortgage insurance, credit reports, and appraisal fees cannot be included.
It’s best to talk to your tax expert about your particular situation.
The Separation of the Land and Building Costs
As mentioned, land cannot depreciate. So to accurately claim depreciation, you need to separate the value of the building and the land it sits on. To do this, you can use the fair market value of each at the time of purchase. You can also use the most recent real estate tax values.
Your Basis in the House
Since you know the basis of the property (what you paid for the house and the land) as well as the prorated value of the home, you can determine your basis in the house. You can discover this by comparing the purchase price to the most recent tax value. For example, if you purchased the home for $100,000 and it is now worth only $90,000, your basis in the home would be 90%.
Optional: Your Adjusted Basis in the House
You may need to increase or decrease your basis because of things that can happen between the time you buy the property and when it is ready for rental. This could include additions, repairs, and certain legal fees.
Which Depreciation Method Should You Use?
There are two methods of depreciation that you can use. The first is the General Depreciation System (GDS) and the second is the Alternative Depreciation System (ADS).
The GDS is the most common; however, you are required to use ADS in the following circumstances:
- The home only has a qualified business use 50% of the time or less
- The home has a tax-exempt use
- You finance the home with tax-exempt bonds
- You use the home primarily for farming.
Final Thoughts on Depreciations of Rental Properties
Depreciation might seem like a complicated tax issue, but as you can now see, if you take a step back and examine your property, it does not have to be that hard at all.
However, it is always in your best interest to consult with your realtor and tax professional for advice that is specific to your situation.
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