Depreciation

Depreciation in real estate allows investors to deduct the value of an asset over its "useful life," as determined by the IRS. For residential rental properties, this period is set at 27.5 years, while commercial properties are depreciated over 39 years. By deducting depreciation, real estate investors can reduce their taxable income, often transforming a potential loss into a profitable venture.

However, depreciation isn't without complexity. The IRS has strict rules about which assets qualify for depreciation, how to calculate it, and how much you can deduct each year. Additionally, when you sell a property, the IRS may reclaim a portion of the depreciation deductions in a process called depreciation recapture. Let's dive into the details of how depreciation works, the benefits it offers, and the rules investors must follow to maximize their tax savings.

How Depreciation Works

In real estate, depreciation allows investors to deduct a portion of the property’s value as an expense on their taxes each year. This deduction reflects the gradual wear and tear or "aging" of the property over time. It applies only to the building itself, not the land, which is considered to have an indefinite lifespan and thus is not depreciable.

Depreciation is calculated using the Modified Accelerated Cost Recovery System (MACRS). Under MACRS, rental properties placed in service after 1986 are depreciated over 27.5 years for residential properties or 39 years for commercial properties. To calculate depreciation, you must first determine the cost basis of the property, which is typically the purchase price minus the value of the land, plus certain allowable closing costs. Once the cost basis is established, you can divide it by 27.5 (for residential properties) to calculate your annual depreciation deduction.

For example, if you purchase a rental property for $260,000 and determine that the land is worth $60,000, your cost basis would be $200,000. Dividing this by 27.5 gives an annual depreciation deduction of approximately $7,272.

Depreciable Assets: Does Your Property Qualify?

To qualify for depreciation, a rental property must meet the following criteria:

1. You own the property: You must be the legal owner, even if the property is financed with a mortgage.
2. The property is used for business or income: It must be rented out or used for another income-generating purpose.
3. The property has a determinable useful life: Residential rental properties are depreciated over 27.5 years, while commercial properties are depreciated over 39 years.
4. The property is expected to last more than one year: Depreciation applies only to properties that will be held for business use beyond one year.

Additionally, only the building is depreciable, not the land. Improvements to the land, such as landscaping, generally cannot be depreciated.

Starting Depreciation: When Does It Begin?

Depreciation begins when the property is "placed in service," meaning when it is ready and available for rental use. This often coincides with the date you begin advertising the property to potential tenants. For example, if you purchase a property on January 1st, spend three months renovating it, and begin advertising it for rent on April 1st, you can start depreciating the property as of April 1st.

You continue to depreciate the property until you have either deducted the entire cost basis or sold or retired the property from service.

Related: 9 Best Real Estate Accounting Software

Depreciation Recapture: What Happens When You Sell?

One crucial aspect of depreciation is depreciation recapture, a process where the IRS reclaims some of the tax benefits you received from depreciating the property. When you sell a depreciated property, the IRS taxes the portion of the sale price that reflects depreciation deductions at a special depreciation recapture rate, which is capped at 25%. The remaining profit from the sale is taxed at the long-term capital gains rate, which can be 0%, 15%, or 20% depending on your income.

Here’s an example to illustrate depreciation recapture:

• You buy a property for $100,000 and depreciate it for 10 years, claiming $3,636 in depreciation deductions each year.
• After 10 years, you sell the property for $150,000.
• You would need to pay capital gains tax on the profit from the sale, which includes $50,000 in profit from the sale and $36,360 in depreciation deductions.
• The $36,360 would be taxed at the depreciation recapture rate (up to 25%), and the $50,000 would be taxed at your long-term capital gains rate.

Depreciation Systems: GDS vs. ADS

Most rental properties are depreciated under the General Depreciation System (GDS). However, some situations require the use of the Alternative Depreciation System (ADS), which spreads depreciation over a longer period. ADS must be used if:

• The property is used for personal purposes more than 50% of the time.
• The property is financed with tax-exempt bonds.
• The property is used primarily for farming or by a tax-exempt entity.

Depreciation and Tax Planning

Depreciation is a powerful tool that can reduce your taxable income, but it requires careful planning. Keeping detailed records of your property's cost basis, depreciation deductions, and any capital improvements is essential. Consulting with a tax professional is also highly recommended to ensure you're taking full advantage of the available deductions while staying compliant with IRS rules.

Ultimately, depreciation is one of the most valuable tax benefits of real estate investing, helping investors lower their tax burden and increase profitability.