Tips on depreciating investment property.
I bought my first investment property last year and I am now preparing my taxes. Can I depreciate the property to reduce my taxable income?
Answer
Yes, absolutely. Actually, the I.R.S. will expect depreciation to be calculated from the sale of an investment property in order to increase the amount of taxable gains you had on the property, so it's in your best interest to make sure you take advantage of depreciation during ownership.
So what can you depreciate? Not only can you depreciate the building, but you can depreciate any additional capital investments you made as well, which carry a minimum depreciation schedule of three years. These are commonly referred to as capital expenditures or CAPEX improvements. Here are some examples of what can be depreciated besides the building itself:
- appliances including refrigerators, washing machines, dishwashers, and stoves
- furnaces
- capital improvements such as a kitchen or bath remodel
- new windows
- full roof replacement
- leasehold improvements such as electrical system overhauls or new septic systems
- landscaping improvements
- legal fees, if carved out separately from the original purchase amount, and
- equipment used to maintain the property, such as landscaping equipment or cleaning appliances.
(For more on how your investment property can be depreciated, see the Nolo article How Landlords Can Deduct Long-Term Assets.)
You will note that land is not included in the list. Land is not a depreciable asset and you cannot take deductions on it, as land was there before the buildings and improvements were put on it, and it will remain once they are long gone. You also can't depreciate repair costs or service contracts. Those can be deducted from your net income as expenses, but are not depreciable items.
The time period for deducting depreciation depends on the type of investment. If the property is a commercial property, then the depreciation period is 39 years (as opposed to 27.5 years for residential property). Using a straight line depreciation method for a commercial property costing $2 million dollars, for example, you would receive an annual deduction of $51,282 ($2M / 39 = $51,282). Your annual net income is thereby reduced by that amount, for tax purposes, reducing the amount of taxes you owe to the IRS.
Unlike the building itself, items such as appliances or equipment typically fall on a shorter five- or seven-year depreciation schedule, because of their expected life. Furnaces on the other hand typically carry a depreciation schedule in line with the building itself, whether it is a residential or commercial property. For a breakdown of depreciable items and their corresponding schedules, see Chapter 2, Depreciation of Rental Property, in IRS Publication 527, Residential Rental Property. Chapter 2 is relevant for commercial properties, however, additional detail can be obtained on commercial investments from Chapter 4 in IRS Publication 946, How to Depreciate Property.
FAQs
The IRS assumes a rental property will lose a certain amount of value every year (typically 3.6%). For as long as you own the property, this loss, also known as depreciation, can be subtracted from your taxable income every year. This, in turn, can lower your taxes and may even drop you into a lower tax bracket.
How much depreciation can you write off on an investment property? ›
By convention, most U.S. residential rental property is typically depreciated at a rate of 3.636% each year for 27.5 years. Only the value of buildings can be depreciated; you cannot depreciate the land buildings are built on.
How do you depreciate property for taxes? ›
To calculate the annual amount of depreciation on a property, you'll divide the cost basis by the property's useful life. In our example, let's use our existing cost basis of $206,000 and divide by the GDS life span of 27.5 years. Your depreciation would be $7,490.91 per year, or 3.6% of the loan amount.
Can I use rental property depreciation to offset ordinary income? ›
The IRS does not allow us to mix passive losses with ordinary income. So, it is not possible to offset ordinary income with rental property losses, whether those losses are due to depreciation or operating expenses.
How do you lower taxes with depreciation? ›
By creating a depreciation expense, the business reduces the number of earnings on which taxes are based, thus decreasing the tax owed. Businesses can take a depreciation deduction by filing Form 4562 with their tax return.
Does depreciation expense reduce both taxes and net income? ›
Depreciation expenses are subtracted from revenue when calculating net income, which means that a company's tax liability may be lower as a result.
What happens if you take too much depreciation on rental property? ›
If you claimed too little depreciation, you must decrease the basis by the amount you should have taken. If you took too much depreciation, you must decrease your basis by the amount you should have deducted, plus the part of the excess you deducted that actually lowered your tax liability for any year.
Can I claim 100 depreciation on my rental property? ›
The IRS code permits bonus depreciation of up to 100% of eligible business assets, thanks to the TCJA Act. Previously, only 50% could be deducted this way, but the act changed the tax code to encourage investment in business growth and assets.
What is the maximum depreciation for a rental property? ›
For a rental property, there is a depreciation period of 27.5 years. This creates a problem because the maximum depreciation period for an asset to be depreciated using bonus depreciation is 20 years.
Does depreciation expense decrease income? ›
It is the net earnings of a company. A depreciation expense reduces net income when the asset's cost is allocated on the income statement. Depreciation is used to account for declines in the value of a fixed asset over time.
A depreciation expense has a direct effect on the profit that appears on a company's income statement. The larger the depreciation expense in a given year, the lower the company's reported net income – its profit. However, because depreciation is a non-cash expense, the expense doesn't change the company's cash flow.
How does property depreciation affect capital gains tax? ›
Depreciation expense taken by a real estate investor is recaptured when the property is sold. Depreciation recapture is taxed at an investor's ordinary income tax rate, up to a maximum of 25%. Remaining profits from the sale of a rental property are taxed at the capital gains tax rate of 0%, 15%, or 20%.
What happens when rental property is fully depreciated? ›
The depreciation deduction lowers your tax liability for each tax year you own the investment property. It's a tax write off. But when you sell the property, you'll owe depreciation recapture tax. You'll owe the lesser of your current tax bracket or 25% plus state income tax on any deprecation you claimed.
