How to Handle Depreciation on Your Rental Property

Rental property, in most cases, is an appreciating asset. However, there’s one time when your property may be considered to be going down in value, or depreciating. That is, when it comes time to file your tax return.

Rental property depreciation refers to the gradual decrease in the value of a property over time due to wear and tear, aging, and other factors. In a sense, it’s true that some aspects of a rental property will experience wear and tear over the years. Depreciation is a useful tax deduction that you can claim that allows you to claim back some of this wear and tear when you file your tax return.

Depreciation is important for investors because it can significantly impact how much tax you end up having to pay. This article will provide strategies on how to handle depreciation on your rental property. including how it works and how it is calculated.  Additionally, the article will provide practical tips and advice for investors who want to better understand and leverage depreciation in their financial planning.

We’ll guide you through the basics of depreciation and show you how to handle it effectively to maximize your profits and minimize your tax liabilities. Whether you’re a seasoned landlord or just starting out, our comprehensive guide will provide the knowledge and tools you need to navigate depreciation easily. 

So, let’s get started!

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What Is Depreciation?

Depreciation of real estate is a crucial tool for owners of rental properties. It enables property investors to minimize their taxable income, and can be a fantastic opportunity to reduce the rental revenue you pay taxes on. 

Here’s how it works:

In most cases, the useful life of a rental property is typically considered 27.5 years for residential properties and 39 years for commercial properties, at least when it comes to taxes. Rental property depreciation allows you to claim the depreciation of the property over the course of 27.5 years. 

First up, it’s important to note that you cannot depreciate the entire property. The land may not be depreciated, only the structure itself. So before you can claim it, you’ll need to determine how much your land is valued at and how much your property itself is valued at.

You might be asking yourself: When does depreciation start? Immediately after the property is rented out, or put into service. For example, let’s imagine that on July 15th you purchase a rental property. You set out 3 months to work on it, and it’s finally ready to rent on September 15th when you start advertising online and in the local papers. You finally find a tenant and the lease starts on December 1st. Because the property was placed in service—ready to be leased and occupied—on September 15th, you would begin depreciating the house in September rather than December when you begin collecting rent.

You can continue to depreciate the property until you have deducted the full cost basis value of the property or until you stop renting out the property. Although, you can continue to deduct depreciation on property that is temporarily not in use. If you make repairs after one tenant vacates the property, you can depreciate it while preparing it for the next.

How Do You Calculate Depreciation?

A rental can be depreciated up to the full value of the structure itself, divided across 27.5 years. This works out as an investor claiming 3.636% of the building’s value each year. So let’s say you have a building that is worth $100,000. You could write off 3.636% each year. That would be $3,636 each year. The resulting depreciation expense is deducted from the pre-tax net income generated by the property. After deducting the depreciation expense, the remaining income is passed to the owner, and taxes are paid based on the owner’s federal income tax bracket.

Depreciation affects your taxes by reducing your taxable income, which can lower your overall tax liability. When you own a rental property, you can deduct the depreciation expense from your rental income, reducing the amount of rental income subject to taxation. For example, if your rental income is $20,000 annually and your annual depreciation expense is $3,636, your taxable rental income would be reduced to just $16,364.

However, it’s important to note that you may be subject to depreciation recapture taxes when you sell a rental property. This is because the IRS requires you to pay back a portion of the depreciation deductions you took while you owned the property. For this reason, it’s important to factor this into your financial planning when considering selling a rental property.

The IRS has very specific rules in place about calculating and claiming depreciation. It’s important to work with an accountant when calculating depreciation. Learn more about how to calculate (and recapture) depreciation.

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How to Claim Rental Property Depreciation

When you rent out real estate, you must report the rental income and expenses for each rental property on Schedule E when filing your annual tax return. This calculates the net gain or loss from renting out the property, which is then reported on your 1040 form. Depreciation is considered an expense and must be included on Schedule E with your Form 1040 tax return. This is where you’ll enter your annual depreciation and all the property taxes, interest, and maintenance expenses you paid all year. You might also need to file Form 4562 to claim some or all of your depreciation.

By properly calculating and including depreciation expenses on your tax return, you can minimize your tax liability and maximize your savings. It’s crucial to ensure that you accurately report all income and expenses and consult with a tax professional for specific advice on your situation.

Understanding Depreciation Recapture

Depreciation recapture refers to the taxable income that arises when the sale price of a depreciated asset exceeds its adjusted cost basis. 

Essentially, when you sell a property or asset that you have previously claimed depreciation expenses for, the IRS requires you to “recapture” a portion of the depreciation as taxable income.

The reason for recapture is that when you claim depreciation on an asset, you are reducing its cost basis for tax purposes. This means that when you sell the asset, you are required to pay taxes on the amount of the gain that exceeds the adjusted cost basis, which includes the previously claimed depreciation.

The amount of the depreciation recapture will depend on the method used to calculate depreciation, the length of time the asset was held, and the asset’s selling price. There are specific rules and formulas that need to be followed to calculate the depreciation recapture, and it is essential to consult with a tax professional to ensure that you are following the correct procedures and minimizing your tax liability.

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Does Depreciation Recapture Apply to a Property Sold at a Loss?

Depreciation recapture is a tax provision that requires taxpayers to pay back a portion of the tax benefits they receive from depreciating an asset when they sell the asset. This tax provision applies when the sale of an asset results in a gain.

If the property is sold at a loss, depreciation recapture does not apply. In fact, if the property is sold for less than the remaining basis after depreciation, the taxpayer may be able to claim a loss on the sale. This loss can be used to offset other gains or income, subject to certain limitations and restrictions.

Can It Be Avoided?

Wondering if you can avoid dealing with rental property depreciation recapture simply by not claiming depreciation in the first place? No, it doesn’t work like that. 

Avoiding the depreciation claim for rental property does not prevent depreciation recapture. This does not work because tax law requires that recapture be calculated on depreciation that was “allowed or allowable,” as defined in Internal Revenue Code section 1250(b) (3).

This means the tax law requires recapturing depreciation claimed on the property, even if the taxpayer did not claim depreciation deductions. This is because the IRS assumes that the property owner is depreciating the property and accounts for the depreciation when calculating the adjusted basis of the property for tax purposes.

When the property is sold, the gain is calculated based on the difference between the sale price and the property’s adjusted basis, including any depreciation claimed or that could have been claimed. Therefore, depreciation recapture will be applicable regardless of whether the taxpayer claimed depreciation deductions or not.

How to Defer Paying Capital Gains Tax

You can, however, defer capital gains by utilizing Section 1031 of the IRS tax code. This section, also known as a 1031 exchange, allows investors to defer paying taxes when they sell investment real estate by reinvesting the proceeds in a real estate investment.

IRC Section 1031 allows real estate investors to defer paying capital gains tax when they sell a property and reinvest the proceeds in another similar property. To qualify for a 1031 exchange, the property must meet certain requirements. 

Here are some general guidelines to determine if your property qualifies:

• Purpose: The property must be held for investment, business, or productive use in a trade or business. Personal residences or vacation homes do not qualify.
  

• Like-Kind Property: The replacement property must be "like-kind" to the relinquished property. This means it needs to be a similar asset.

• Timing: The investor must identify potential replacement properties within 45 days of the sale of the original property and must complete the purchase of one or more of those properties within 180 days.
  

• Use of a Qualified Intermediary: Proceeds from the sale must be held in escrow and then used to buy the property. The investor must use a qualified intermediary to facilitate the exchange and cannot receive any proceeds from the sale of the original property.
  
  

By completing a 1031 exchange, the investor can defer paying capital gains tax on the sale of the original property. However, it’s essential to note that the tax is only deferred, not eliminated. However, when used correctly, there is no limit on how frequently an investor can do 1031 exchanges.

Additionally, not all properties are eligible for a 1031 exchange. It’s also important to work with a qualified intermediary and consult a tax professional to ensure the exchange is completed correctly and complies with IRS regulations.

Depreciation is not something to be feared, in fact, it may end up being beneficial to you as a landlord when tax time comes around. Understanding depreciation takes time, but it’s an essential aspect of real estate investing. If you find yourself overwhelmed, find yourself a trusted tax professional to walk you through the process.

Ready to get started with rental investments? If this sounds like you, be sure to check out how to grow your portfolio See how you can get started today. And if you’re looking for new markets to invest in, be sure to check out your free guide: How to Find and Buy the Perfect Investment Property.

Please Note: This information is intended to inform and to guide. It is not meant to serve in place of tax advice from a licensed tax professional. Please consult a tax professional to see how the tax law applies to your individual situation and to see which tax strategies you can employ as well as deductions that you may be able to take.