One of the greatest advantages of investing in real estate is depreciation, as many investors know. Along with other deductions such as insurance, property tax, and maintenance, depreciation can greatly lower your federal taxable income taxes.
But how does depreciation really work?
When to Use Depreciation
Depreciation allows you to spread the initial price of a rental property – excluding the land – over time. As an investor, you can use the depreciation deduction for the purchase price of a rental property and for other capital investments (CAPEX) associated with the building. IRS guidelines mandate that in order to be considered depreciable, you must own the property even if the bank holds a mortgage or there is another debt.
The property must be used for an income-producing activity or for your business. You must anticipate that the property will last over a year and that it is expected to wear out or become obsolete over the course of its “useful life.” If you sell the property or no longer use it for an income-producing activity such as rental income or for your business, you are not entitled to apply the depreciation deduction.
Claiming Depreciation
Depreciation starts when your property is available as a rental. That means that even if you do not find a tenant immediately, you can start your depreciation deduction on the date when you began advertising for a tenant since that is the date the property was “placed in service.” Depreciation for investors continues until you have deducted the entire cost of the property. If you convert the property to personal use, sell it, use it in an exchange or walk away from it, depreciation ends. If the property is destroyed, say in a fire or flood, you are no longer able to claim a depreciation deduction.
It is important to keep in mind that depreciation claims can continue even if you take the unit off the market temporarily and then rent it out again. For example, you may decide to make improvements or repairs when your tenant leaves before renting it out to another tenant. If you own a commercial property and you stop using a particular machine because there is a temporary drop in the market for the product made that machine, you can still claim depreciation.
How to Figure Out Depreciation
Now that you have determined that your rental property is eligible for depreciation, you need to work out the amount of depreciation you can deduct every year. The time period for depreciation varies according to the type of investment. For residential property, the depreciation period is 27.5 years. For commercial property, it is 39 years.
Since you have entitled to a depreciation deduction for the building but not the land, you must determine the value of the building at the time of the purchase. You can use the fair market value system or look at the real estate tax values. Appliances and other equipment usually have a 5-7 year depreciation schedule.
• The Straight Line Method
According to the IRS, the Straight Line Method of depreciation calculation allows you to deduct a particular amount for depreciation every year over the “useful life” of the property. After making some mandated deductions, you will figure out the total amount of depreciation you are entitled to over the life of the property. When you divide that balance by the number of years in the useful life, you will come up with the annual depreciation deduction amount. If you use the property for less than a year (for example, the year you buy the property), you calculate your depreciation deduction based on the number of months you used the property for income-producing activity.
• Repairs and Improvements
The IRS states that you have to treat improvements to the property separately when you file for depreciation. An improvement is defined as a partial replacement or an addition to the property. The improvement restores the property, makes it better, or adapts it for new use. Repairs are treated as a one-off deductible expense. For example, a repaired roof is a rental expense, while a fully replaced roof is an improvement and can be depreciated. If you add a new item or upgrade an existing item, you can usually list it as an improvement.
Depreciation is an excellent tool for investors who want to boost their bottom line. Be sure to list all the costs associated with your investment property and determine which are simple repairs and which can be listed as an improvement for long-term deductions. Taking the time to claim depreciation is well worth the effort since in some cases you can lower your federal tax liability to the extent that you find yourself in a lower tax bracket.
Real estate is a popular investment choice because it can offer a stable asset that produces an immediate cash flow. You can leverage the capital investment to build wealth faster…
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