The subject of depreciation on real estate investments and its impact on taxes made headlines after President Trump stated that depreciation was the reason for the $1 billion in losses he suffered before he was elected—losses that allowed him to avoid paying taxes for many years.
Write-offs from depreciation can impact real estate investors’ taxes in significant ways, saving them hundreds to thousands of dollars per year. Real estate depreciation is defined as an income tax deduction that allows a taxpayer to recover the cost (or other basis) of a real estate investment. The depreciation is realized as a type of deduction that reduces the investor’s taxable income.
Unlike rental expenses—which include items like repair and maintenance expenses, travel expenses related to property management, home office expenses, property taxes, mortgage insurance, property insurance, and professional services—that can be deducted from rental income earned the year the money was spent, depreciation deducts the cost of buying and improving a rental property over the useful life of the property.
While depreciation sounds like a sure bet for reducing real estate investors’ taxes, it is important to note that the IRS has very detailed and complex rules about how depreciation can be used as a tax deduction. Rental property owners may have questions about how those rules work and how they apply to their own investment situation, including:
Is my property eligible for depreciation?
First, investors should understand which rental properties the IRS considers depreciable. Property only falls under the depreciable umbrella if the investor owns it (even with debt), it is used in the investor’s business or to produce income, the property has a ‘useful life’ (meaning it deteriorates over time), and this useful life is expected to last more than a year.
In addition, to be eligible for depreciation, the property cannot be put into service and disposed of in the same year. Also, land is not depreciable, and owners cannot deduct for land costs such as clearing, planting, and landscaping.
Owners can deduct for depreciation up until the point when the entire cost or basis in their property has been deducted or until the asset is considered ‘retired from service’—if the property has been sold or exchanged, converted to personal use, abandoned, or destroyed. Also, deduction claims can be made on a property that is temporarily not in use, such as the period after one tenant leaves and before another tenant occupies the space—as long as at least one repair has been made in preparation for the new tenant.
How do I calculate deductions for depreciation on my property?
Once investors have determined that their property is eligible for depreciation, they will need to understand how to calculate depreciation deductions.
Depreciation is determined by the investor’s basis in the property, the recovery period (the time period for which the depreciation is being claimed), and the depreciation method used. Since 1986, depreciation has been calculated using the Modified Accelerated Cost Recovery System (MACRS), an accounting system that amortizes costs and deducted depreciation over 27.5 years for a residential asset and 39 years for a commercial asset—the span of a property’s useful life, as defined by the IRS. Using MACRS, with the help of a qualified tax account, investors can ascertain the cost of the property and separate the cost of land from the cost of buildings to calculate their basis in the property, determining an adjusted basis if necessary.
A tax accountant will also help investors figure out whether the General Depreciation System (GDS) or the Alternative Depreciation System (ADS) MACRS applies to the property, although in most cases the GDS is used. Once that system is determined, the recovery period can be calculated, applying a certain percentage for each year the property was in service.
How much will depreciation affect my taxes?
Rental property investors can include depreciation as one of the expenses on Schedule E when they file their yearly taxes. The tax liability will be reduced according to which tax bracket the investor is in. That percentage will determine the amount of the deduction.
Depreciation can help investors by spreading out the purchase price of a property over a number of years and allowing them to claim deductions during each of those years. It is less of a wealth-building strategy than a means for offsetting investment losses.
The IRS does change the rules for depreciation on occasion, so it is wise to work with a qualified tax accountant when calculating depreciation to avoid inadvertently breaking the rules and negating the value of this important investment tool.
Related: How Preferred Return Can Affect Your Real Estate Investment
As an expert in real estate taxation, I've delved deeply into the intricate details of the subject, keeping abreast of changes in regulations and understanding the nuanced strategies that can significantly impact investors. The article on real estate depreciation and its tax implications touches upon a crucial aspect of real estate investment that demands a comprehensive understanding.
Depreciation, as mentioned, is a potent income tax deduction tool that enables investors to recover the costs of their real estate investments over time. The notion of claiming depreciation as a tax deduction is indeed a compelling strategy, and the magnitude of its impact on taxes is noteworthy. President Trump's case, as cited in the article, is a prominent example of how leveraging depreciation can result in substantial tax benefits, potentially saving investors hundreds to thousands of dollars annually.
The article articulates the distinction between depreciation and other rental expenses adeptly. While typical rental expenses are deducted in the year they are incurred, depreciation spreads the costs of property acquisition and improvements over the property's useful life. This fundamental disparity underscores the unique and long-term nature of depreciation as a tax-saving mechanism.
Furthermore, the article delves into the intricacies of IRS rules governing depreciation. Notably, eligibility for depreciation hinges on factors such as property ownership, usage for income generation, a useful life exceeding one year, and exclusion of land costs. The temporal aspects, such as not putting a property into service and disposing of it in the same year, are crucial considerations.
The calculation of depreciation deductions involves a meticulous understanding of the investor's basis in the property, the recovery period, and the depreciation method employed. The Modified Accelerated Cost Recovery System (MACRS) is highlighted as the system used since 1986, providing a structured approach to amortizing costs over specific periods.
As for the impact on taxes, the article succinctly outlines the process for including depreciation as an expense on Schedule E during annual tax filing. The reduction in tax liability is contingent upon the investor's tax bracket, emphasizing the direct correlation between tax savings and depreciation.
The article aptly concludes by addressing the dynamic nature of IRS rules, underscoring the importance of collaboration with qualified tax accountants. This collaborative approach is essential for navigating the evolving landscape of tax regulations, ensuring compliance, and maximizing the benefits of depreciation as a pivotal tool in real estate investment.
In summary, real estate depreciation, with its intricate calculations and nuanced IRS regulations, is a critical aspect of tax planning for investors. Understanding the eligibility criteria, calculation methodologies, and potential tax savings is indispensable for any serious real estate investor looking to optimize their financial strategy.
