Understanding Depreciation on Rental Properties
John Smith, a real estate investor, recently had a question for his Accountant. “Can you explain to me, in simple terms, what is Depreciation on rental properties?” The Accountant provided a definition of what Depreciation is and how it’s used in relation to rental properties.
What is Depreciation?
Depreciation is an expense used to recover the cost of a tangible asset over its useful life. It allows the owner of a rental property to expense a portion of the cost of the rental unit every year. That expense is equal to the cost of the rental property divided by the estimated useful life of the building.
Is Depreciation Tax Deductible?
Yes, certain Depreciation expenses are tax deductible. The Internal Revenue Service (IRS) allows rental property owners to claim a dollar-for-dollar deduction on their income taxes for the amount of Depreciation they take in any given year.
How to Calculate Depreciation on a Rental Property?
Steps to calculate Depreciation on rental units are as follows:
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- Gather the relevant information about the rental unit, such as the purchase price, estimated useful life, and current market value.
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- Divide the purchase price by the estimated useful life of the rental unit.
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- Subtract the current market value of the rental unit from the purchase price.
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- Multiply the remaining amount (the adjusted basis) by the applicable depreciation rate.
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- The result is the total amount that can be claimed as a deduction for the applicable tax year.
For example, let’s assume John Smith purchased a rental property for $100,000 with an estimated useful life of 10 years and a current market value of $80,000. Here is how the calculation for Depreciation would look:
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- The purchase price is divided by the estimated useful life. 100,000/10=10,000.
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- The current market value is subtracted from the purchase price. 100,000-80,000=20,000.
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- This adjusted basis is multiplied by the applicable rate. 20,000 x 20% = 4,000.
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- The final result is the total deductible expense for the tax year. 4,000 = 4,000.
How often Should Depreciation be Taken?
Depreciation should be taken every tax year that the rental property is in service. For example, if the property was purchased on July 1, an owner would be entitled to take half of the total Depreciation for that tax year, and the other half for the following year.
What is Straight Line Depreciation?
Straight line Depreciation is the most common method used by rental property owners to calculate Depreciation for tax purposes. It assumes that the asset will be depreciated evenly over its useful life. For example, if the useful life is 10 years, the asset will be depreciated at a rate of 10% each year for 10 years.
What is Accelerated Depreciation?
Rather than spreading out the Depreciation over the entire life of the asset, accelerated Depreciation methods allow the owner to take more of the deduction up front and less as time goes on. This is useful in many cases, such as when the rental property has a faster depreciation rate than the straight line method.
Do I Need To Record Depreciation On My Tax Return?
Yes, rental property owners must correctly report their Depreciation on their tax returns. While there are some exceptions, it’s generally best for the owner to consult with a tax professional to ensure they are in line with all applicable laws and filing requirements.
What Is Bonus Depreciation?
Bonus Depreciation is an additional tax deduction that helps rental property owners recover the cost of their assets more quickly. The terms and conditions of Bonus Depreciation can vary and generally expire after a certain period, so it’s important that owners keep on top of their eligibility.
Are There Limits to How Much Depreciation Can be Taken?
Yes. For tax purposes, rental property owners are limited to the amount of Depreciation that can be taken each year. Generally, the maximum amount of Depreciation that can be taken is equal to the adjusted basis of the asset.
Conclusion
Depreciation is a useful tool for rental property owners to take advantage of when it comes to filing their taxes. It allows the owner to take a dollar-for-dollar deduction from their taxable income each year and can help to reduce the burden of taxes on the rental property.
The major points that every rental property owner should know about Depreciation include what it is, how it’s calculated, and how it’s used. By understanding how to calculate and use Depreciation, owners can maximize their tax savings. Always remember to consult with a tax professional to make sure everything is being done correctly.
What are the types of expense deductions related to rental property depreciation?
1. Straight-Line Depreciation: With straight-line depreciation, the value of the rental property is reduced gradually over the course of the useful life of the asset. The same amount of depreciation is claimed each year.
2. Accelerated Depreciation: Accelerated depreciation allows a larger deduction in the earlier years of the asset’s useful life, with a smaller deduction claimed in the later years.
3. Cost Segregation Depreciation: Cost segregation is a process of breaking down the different elements of a rental property into smaller components that each qualify for different depreciation periods, thereby allowing for accelerated deductions in the earlier years. Explore our solutions on finance and pricing for UK landlords
4. Section 179 Deduction: Rental property owners may qualify for the Internal Revenue Service’s Section 179 deduction if the rental property was put into use in 2020 or later. This deduction allows you to deduct the full cost of certain rental property investments in the first year.
5. Bonus Depreciation: Bonus depreciation allows rental property owners to deduct a percentage of the cost of certain qualified property placed in service during the year. For 2020 and 2021, the bonus depreciation deduction amount is 100%.
By understanding the different types of deduction and how they apply to rental properties, owners can save a significant amount of money on their taxes. Owners should discuss their individual situation with a qualified tax professional to ensure that they take advantage of all the deductions available to them.