You’ve probably come across the concept of depreciation for equipment and other business assets, but did you know that real estate can also depreciate? Depreciation is actually one of the most valuable deductions for real estate investors. It helps lower your taxable income each year that you have a property in service and available for rent.
But what exactly is depreciation in real estate, and how does it function?
The Meaning of Depreciation in Real Estate
Real estate depreciation refers to the gradual loss of value that a property experiences over time due to normal wear and tear and regular use. Essentially, as a property ages, its value decreases compared to when it was first purchased.
To help real estate investors mitigate the cost of buying investment properties, the IRS offers an annual depreciation deduction. For residential real estate, the IRS calculates depreciation over a period of 27.5 years, which is considered the average useful life of such properties.
This depreciation deduction can help offset the income earned from rental properties, such as rental income or income from additional amenities provided. It’s important to note that depreciation is not actual cash that you pay or receive; rather, it’s an accounting concept that reduces your taxable income on paper, thereby lowering your tax liability.
How Is Real Estate Depreciated?
The IRS employs the Modified Accelerated Cost Recovery System (MACRS) to depreciate real estate. Investment properties purchased after 1987 fall under this system and can be depreciated over 27.5 years, which represents the typical useful life of such properties.
What Is the Most Common Depreciation Method?
There are two types of depreciation methods: straight-line and accelerated. The most commonly used method is straight-line depreciation. This method is the simplest, as it allocates a fixed amount of depreciation each year based on the property’s cost basis.
On the other hand, accelerated depreciation allows property owners to deduct a larger percentage of the cost basis during the initial years, but it leaves no depreciation deductions for the remaining useful life of the property.
Calculating depreciation
To calculate real estate depreciation, you must know the following:
- Property’s cost basis (purchase price, plus any other acquisition costs)
- Expected useful life (IRS uses 27.5 years)
When calculating the property’s cost basis, determine its purchase price plus any capital expenditures, including:
- Legal fees
- Surveys
- Title insurance
- Recording fees
From the cost basis, you must subtract the land’s value, as land doesn’t depreciate.
For example, you purchased a property for $275,000. The appraiser determined the lot was worth $20,000, and your capital expenditures to purchase the property are $4,000. Your cost basis for the property is as follows:
- $275,000 purchase price
- Subtract $20,000 land value
- Add $4,000 capital expenditures
Your cost basis is $259,000. If you put the property in service by Jan. 1, you’d divide $259,000 by 27.5 years for an annual depreciation of $9,418.18.
Tax Benefits of Depreciation on Real Estate
Depreciation significantly impacts your annual tax liability by acting as an expense on Schedule E, which directly reduces your taxable income.
By lowering your income, depreciation affects your net gain or loss on the property. When combined with other expenses, it helps to reduce your overall tax liability.
What Can’t You Depreciate?
In addition to land, there are several costs that cannot be included in your acquisition costs to determine a property’s cost basis.
These non-depreciable costs include certain settlement fees, such as:
- Origination points
- Mortgage insurance premiums
- Fire insurance premiums
- Appraisal fees
Additionally, you cannot depreciate property that you bought and sold within the same year or equipment used for capital improvements to the property.
When Can I Start Depreciating My Property?
You can start depreciating your property once it is placed in service or made available for use.
For instance, if you purchase a rental property on January 5 and spend three months renovating it, making it available for rent on May 1, you can begin taking depreciation from May 1, even if it hasn’t been rented out yet.
How Much Is Depreciation?
The amount of depreciation you can take varies based on the property’s cost basis and when you put the property into service. You cannot deduct depreciation for times you sit on the property idle, not making it available for rent.
For each full year the property is in service, you can deduct 3.636% of your cost basis. If you put the property in service midyear or any time after Jan. 1, you’ll get a prorated amount of depreciation for that year. The prorated amount depends on when you put it into service:
This means you can depreciate $3,636 each year for every $100,000 in a property’s cost basis for each full year the property is in service.
What Is Depreciation Recapture?
Depreciation provides a significant tax benefit while you own investment properties. However, when you sell the property for a profit, the IRS requires you to pay taxes on the depreciation you’ve claimed, known as depreciation recapture.
Depreciation recapture involves paying taxes at a rate of 25% on any depreciation deductions you’ve taken during the ownership of the property.
Any capital gains exceeding the depreciation recapture are taxed at your capital gains rate, which can be 0%, 15%, or 20%, depending on your tax bracket.
Strategies to Manage Depreciation as a Real Estate Investor
To effectively manage depreciation and maximize your deductions, consider these strategies:
- Perform regular maintenance to extend the property’s useful life.
- Make improvements and upgrades to increase the property’s cost basis.
- Reinvest profits using a 1031 exchange to defer depreciation recapture.
Final Thoughts
Understanding depreciation in real estate is crucial because it represents one of the key deductions available to real estate investors. By improving and maintaining your properties, you can continuously enhance your depreciation deductions.
To avoid depreciation recapture, consider utilizing 1031 like-kind exchanges to defer taxes until you decide to stop investing in real estate. While actively investing, depreciation remains one of the most valuable deductions you can take advantage of.
