Key Takeaways
- Depreciation allows rental property owners to recover the cost of their investment over time through tax deductions, provided the property meets IRS eligibility requirements.
- Choosing the correct depreciation system, GDS or ADS, is critical, as the decision is permanent and directly impacts the size and timing of deductions.
- Accurate cost basis calculations, proper land valuation, and strong recordkeeping are essential to maximizing depreciation benefits and avoiding costly mistakes during tax season.
Depreciation is one of the most important tools a landlord can use to maximize profits. Through depreciation, owners can account for the effect of wear and tear on the value of their investment property, allowing them to save thousands of dollars that would have gone into paying property taxes.
In this article, by KRS Property Management Lynchburg, we’ll help you understand how depreciation works, what the eligibility criteria are, and how to calculate it.
Depreciation in Rental Properties
The concept of depreciation is based on the idea that, through usage, wear and tear, and obsolescence, physical assets, like rental properties, lose their value over time. Landlords can calculate this loss in value and claim it on their returns during tax season.
This deduction can be claimed over a predetermined period of time, until the entire cost basis for the property is recovered or it is sold. The period over which depreciation may be claimed for a rental property is known as its recovery period.
For commercial real estate, the recovery period is 39 years, and 27.5 years for residential properties. But not all rental properties are eligible for depreciation. To qualify, the rental must meet the following criteria:
- You, the owner, must hold the legal property title.
- The property must be used for a business or an income-generating activity, such as renting it out.
- The property must have at least one permanent structure, and it must have a calculable lifespan.
System for Rental Property Depreciation
Under the Modified Accelerated Cost Recovery System (MACRS) there are two systems for calculating depreciation on a rental property. These are the General Depreciation System (GDS) and the Alternative Depreciation System (ADS).
To calculate depreciation on your rental, you must determine the right method for your residential rental property. This is important because you may not change a depreciation method after you choose it. You must use it throughout the useful life of the rental property.
General Depreciation Systems (GDS)
The GDS is the standard method used by most rental property owners; it is automatically applied unless ADS is required or the property owner elects to use ADS. This method specifies a recovery period of 27.5 years, and the depreciation deduction is the same for every month.
Alternative Depreciation System (ADS)
Under the ADS, the useful life of the rental property extends to 30 years or 40 years for properties placed in service on or before December 31st 2017.
This method also uses a straight-line depreciation method, which means that the depreciation deduction is the same for every month. Due to the longer recovery period, the monthly deductions under ADS are smaller, so it’s important to understand how this impacts cash flow and tax returns.
The Alternative Depreciation System can be applied to the following types of properties:
- Buildings with a qualifying business that uses it 50% or less of the time.
- Buildings mostly used for farming.
- Tax-exempt properties or those financed using tax-exempt bonds.
- Properties owned by certain kinds of businesses, like a REIT.
- Buildings with income-generating businesses that are tax-exempt.
- Properties used by a foreign person or entity not subject to US income taxes.
Calculating Depreciation on Rental Properties
Here is how to calculate depreciation:
Calculate the Cost Basis for the Rental Property
The cost basis of the property is the purchase price minus closing costs and settlement fees, as well as the cost of any capital improvements you made to the property before or shortly after you placed it in service.
Closing costs and settlement fees include the abstract, utility installation, legal, and recording fees, as well as transfer taxes, surveys, title insurance, and any money owed by the seller that you agree to pay.
Determine the Depreciable Value of the Property
Since land does not have a limited useful lifespan, it cannot be depreciated. Therefore, you must deduct the value of the land that the building sits on from the cost basis of the rental property.
To find the value of land, consult your county/city assessor's website for their published land values. Apply this percentage to the purchase price of the property. You may also hire a professional appraiser for a more precise value.
Calculate Annual Depreciation
To determine the annual depreciation for the property, take the depreciable value and divide it by 27.5. Or, you can multiply the cost basis by 3.636%, the depreciation percentage used by the IRS. This method is the only one accepted by the IRS for depreciating rental properties.
Mistakes to Avoid When Depreciating a Rental Property
Here are some of the common mistakes landlords make when depreciating a rental property:
- Using the Wrong Method: This usually comes from making a decision about which depreciation method to use before you understand the long-term implications.
- Poor Recordkeeping: Without proper bookkeeping, it’s impossible to establish the legal basis for making any kind of tax deductions for your property.
- Not Claiming Depreciation: Always claim depreciation. Not taking your deductions now will not help you save on taxes in the future.
- Valuing Your Land Incorrectly: When trying to determine depreciable cost, value the entire land, not just the portion where the building sits.
- Confusing Repairs with Improvements: To calculate your rental’s cost basis, you must know the distinctions between capital improvements and repairs.
Bottom Line
Understand the impact of depreciation on your property’s value and annual taxes can save you a lot of money long-term. Consulting with real estate professionals can help you make the most of your investment. Contact our experts at KRS Property Management Lynchburg today!