Property depreciation is a money-saving tool for the owners of rental property. Landlord can deduct the cost of improvement from the taxes he is supposed to pay. It reduces the taxable income and you can save some money. Real estate investment is a lucrative investment. It can be a steady source of income without much time investment. You pay all rental expenses with rental income and make a profit as well.
Any rental property comes with a variety of expenses, some common ones are mortgage, property tax, insurance, and repair costs. If you hire a property manager, you need to pay his fee as well. The rental income should be enough to cover these costs and make some profit as well.
What is real estate depreciation?
Real estate depreciation is a tax deduction, but it is not the same as other deductions. In this process, expenses of buying and improving a property are deducted. It’s not the one deduction but you can divide it over the period of a year or even the useful life of the property. There is a complete set of rules regarding rental property depreciation and you have to get complete Information before you list your property.
Characteristics of depreciated property
Every property is not depreciated. Some characteristics of the property make it depreciated. Here are these factors, which can help you to evaluate if your property is depreciated or not.
You must have ownership of the property.
Property is used to generate income, either in your business, rent, or in any other way.
You must be able to determine the life of the property. It deteriorates with time and loses its value. The reasons for decay can be natural and consistent use as well.
The expected life of the property must be more than a year, at least.
If the property fulfills these criteria, but you stop using it for business purposes within a year, you cannot depreciate it. Keep in mind, land cannot be depreciated, it must be useful property building.
Duration of the depreciation period
Landlords can start deducting depreciation when they start using the property for rental purposes. The actual time starts when you list your house and it’s ready for rent. If you don’t get a tenant for a few months, you can still count the depreciation from the time of listing. Depreciation deduction will continue until you deduct the entire cost. You will stop the deduction if the property is not available for business purposes. If you sell the property or exchange it or it’s destroyed due to any reason, you cannot use it for depreciation. However, if the property is unavailable temporarily, you can claim depreciation even for that period. For instance, if a tenant moves out and the house is vacant and you are repairing and maintaining the house, you can deduct depreciation for this time.
Depreciation depends on three basic factors. First, the basis of the property, the time required to recover the cost, and the method of depreciation you will use. MACRS or Modified Accelerated Cost Recovery System is the method used to calculate depreciation. It was introduced in the 1980s and still, the same system is used. It uses a recovery period of 27.5 years, which is considered a useful life for any property. It is recommended to hire a professional lawyer to calculate depreciation, but you can do it in a few basic steps.
Evaluate the basis of property
The money you paid to buy this property is the basis of the property. It can be in cash or mortgage. Other than the price of the property, other costs like transfer taxes, survey fees, legal fees, and title insurance can also be added to the basis. However, things like fire insurance premiums and mortgage insurance premiums are not included in the basis.
Segregate cost of building and land
Depreciation is deductible for the building only and not for the land. So, you have to separate the two before calculating depreciation. For the calculation, use the market value of the land and building separately, when you have brought this property.
Decide your basis in the property
Once the value of the house and the basics of the property are clear, you need to determine your basis in the house. Basis means the amount that can be depreciated. Your basis would be 10% in the land and 90% in the house. A professional can help you to understand it better.
In special cases determine the adjusted basis
In some cases, you need to reevaluate your basis. For instance, you buy a property and add an expensive amenity, which has a useful life of more than a year, so you can add the cost before you calculate depreciation. So, any amount you spent on the maintenance of the property after buying it and before listing it, can be added to the depreciation cost.
Use appropriate MACRS
There are two types of MACRS. One is called the general Depreciation system and the other is Alternative Depreciation System. Usually the General system applies to most rental properties, Alternative system is used in some special cases.
A general depreciation system will be used for common properties. But if the use of the property for business is 50% of the time or even less, an Alternate system will be used. Moreover, if the property is used for farming or exempted from tax for any reason, depreciation will be calculated through Alternation Depreciation System or ADS. A professional tax lawyer can help you appropriately calculate depreciation for rental property.
After determining the appropriate MACRS system, you can calculate the recovery period too. In the general system, for residential properties, the recovery period is 27.5 years. However, in the Alternate system, this period can be 30 years for the same property. After that, calculate the depreciation amount per year. This is the focus of all the calculations you have done previously. An equal amount of money will be depreciated until the property is used for business.