We have all heard about the tax advantages of owning rental real estate. However, most rental property investors do not understand many of the tax advantages, especially real estate depreciation. No discussion on real estate investing would be complete without a brief explanation of what real estate depreciation is and how it works.
Real estate depreciation is an important tool for rental property owners. It allows you to deduct the costs of buying and improving a property over its useful life and lowers your taxable income in the process.
Tax Write-Offs
Investing in rental property can prove to be a smart financial move. For starters, a rental property can provide a steady source of income while you build equity and the property appreciates over time. There are also tax benefits. You can deduct your rental expenses from any rental income you earn, thereby lowering your tax liability. Most rental property expenses, including mortgage insurance, property taxes, repair and maintenance expenses, home office expenses, insurance, professional services, and travel expenses related to management are deducted in the year you spend the money.
Real Estate Depreciation
Another key tax deduction—the one for depreciation—works differently. Depreciation is the process used to deduct the costs of buying and improving a rental property. Rather than taking one large deduction in the year you buy (or improve) the property, depreciation distributes the deduction across the useful life of the property. The IRS has very specific rules regarding depreciation, and if you own rental property, it’s important to understand how the process works.
“Deprecation is one of the biggest tax advantages for rental property owners because it provides an annual tax deduction that really isn't an expense. Let's say you have a rental property that produces $6,000 in annual income after expenses. A $4,000 depreciation expense will reduce your property's taxable income to just $2,000."
According to the IRS, you can depreciate a rental property if it meets all of these requirements:
You own the property (you are considered to be the owner even if the property is subject to a debt).
You use the property in your business or as an income-producing activity.
The property has a determinable useful life, meaning it's something that wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes.
The property is expected to last more than one year.
Even if the property meets all of the above requirements, it can’t be depreciated if you placed it in service and disposed of it (or no longer use it for business use) in the same year. Land isn't considered depreciable since it never gets "used up." And in general, you can't depreciate the costs of clearing, planting, and landscaping, as those activities are considered part of the cost of the land.
When Does Depreciation Start?
You can begin taking depreciation deductions as soon as you place the property in service or when it's ready and available to use as a rental.
Here's an example: You buy a rental property on May 15. After working on the house for several months, you have it ready to rent on July 15, so you begin to advertise online and in the local papers. You find a tenant, and the lease begins on Sept. 1. As the property was placed in service—that is, ready to be leased and occupied—on July 15, you would start to depreciate the house in July, and not in September when you start to collect rent.
You continue to depreciate the property until one of the following conditions is met:
You have deducted your entire cost or other basis in the property.
You retire the property from service, even if you have not fully recovered its cost or other basis. A property is retired from service when you no longer use it as an income-producing property—or if you sell or exchange it, convert it to personal use, abandon it, or if it's destroyed.
You can continue to claim a depreciation deduction for property that's temporarily "idle" or not in use. If you make repairs after one tenant moves out, for example, you can continue to depreciate the property while you get it ready for the next.
The Bottom Line
Depreciation can be a valuable tool if you invest in rental properties, because it allows you to spread out the cost of buying the property over decades, thereby reducing each year’s tax bill. Of course, if you depreciate property and then sell it for more than its depreciated value, you'll owe tax on that gain through the depreciation recapture tax.
Because rental property tax laws are complicated and change periodically, it’s always recommended that you work with a qualified tax accountant when establishing, operating, and selling your rental property business. That way, you can be sure to receive the most favorable tax treatment and avoid any surprises at tax time.
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