Key Takeaways
- Depreciation Maximizes Tax Benefits: Rental property depreciation is a tax deduction that offsets the decline in property value over time, potentially saving landlords thousands in taxes annually.
- Accurate Calculation is Critical: Landlords must separate the cost of land from structures, apply the correct recovery period, and account for capital improvements to properly calculate depreciation.
- Professional Guidance Reduces Errors: Partnering with a property management company like The Maryland and Delaware Group PM can ensure compliance, accurate deductions, and optimized financial outcomes.
As a landlord, understanding depreciation is essential. For starters, it can help you maximize your tax benefits, as well as ensure legal compliance with tax regulations.
Depreciation is one of the tax deductions the Internal Revenue Service (IRS) allows landlords to make to account for their rental investment’s normal wear and tear. If filed correctly, it can save you thousands in tax dollars every year.
In this guide by The Maryland and Delaware Group PM, you’ll learn all the basics of depreciation and property value.
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What is Rental Property Depreciation?
Over time, the value of a rental property will gradually decline as a result of normal wear and tear, obsolescence, and age. Luckily, the Internal Revenue Service makes this tax deductible to help rental property owners recoup these losses over a certain duration of time.
For as long as you own the property, the IRS will allow you to subtract this loss from your taxable income every year. This can help you minimize your tax bill for an optimal return on investment (ROI).
For residential real estate, the recovery period is 27.5 years, and for commercial real estate, it is 39 years. These are the lengths of time that you can claim the depreciation value on your property taxes.
Rental property depreciation functions as a way of benefiting from an expense without writing a check.
Please note, however, that you cannot claim the total amount all at once. Rather, you must spread out the deduction over several years.
What are the Requirements for Rental Property Depreciation?
Please note that not all types of real estate properties automatically qualify for depreciation. The following are the strict eligibility requirements that a property must meet:
- You must own the property legally, even if you’re still making mortgage payments. Property managers, lessees, and residents don’t qualify.
- The rental property must be generating a rental income. Primary residences and vacation homes don’t qualify
- The property must have at least one permanent structure.
- The property must have a useful life extending at least one year.
- The property must have a determinable useful life.
Please note that land itself doesn’t qualify for depreciation per the IRS requirements. This is because, unlike structures, it doesn’t wear out over time.
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How can Landlords Calculate a Property’s Depreciation?
To do so, you must first determine the cost basis of the property. This is the total acquisition cost of a property, including the closing costs. You must then find the depreciation basis, which is the cost basis minus the cost of land.
Suppose, for instance, that you bought an investment property for $250,000. You also paid $5,000 in closing costs, and $10,000 in capital improvements. This meant that the purchase price amounted to a total of $265,000.
To compute the depreciable basis, you’ll need to subtract the cost of the land. If, for instance, the value of the land is $70,000, then that would result in a depreciable basis of $195,000 ($265,000 - $70,000).
Next, calculate the annual depreciation. Under the Modified Accelerated Cost Recovery System (MACRS) and the General Depreciation System (GDS), the recovery period is 27.5 years.
So, to calculate the annual depreciation, simply divide the depreciation basis by the recovery period. ($195,000/27.5 = $7090.91). This comes to about $591 a month.
You’ll also need to apply the mid-month convention. The IRS treats a rental property as being placed in service in the middle of a month, regardless of the actual lease date.
For the sake of our calculation, let’s assume that you leased the property on April 15th . From April 15th through to December 31st , that would total to eight and-a-half months. The depreciation for the first year would come to $5,023.50 ($591X8.5).
For the subsequent years, the depreciation would be for the full 12 months. ($591X12= $7,092).
The 8.5 months, plus a full 26 (26X12 =312 years would total to 320.5. Therefore, the remainder would be 9.5 months (330-320.5=9.5). This means that the depreciation for the final year would be $5,614.50 ($591X9.5).
What are the Common Mistakes and Pitfalls to Avoid?
To maximize depreciation deductions when filing taxes, the following are some mistakes you’ll want to avoid:
- Not separating the value of land from the asset’s value when calculating the depreciable basis.
- Not starting depreciation from the date you placed the property in service, but rather placing it on the purchasing date.
- Not accounting for any capital improvements you’ve made on the property.
Conclusion
There you have it. The important basics you need to know about depreciation and property value, and how you can maximize your deductions during the tax season. You must, however, pay careful attention to the details lest you risk making serious mistakes.
For expert help, consider reaching out to The Maryland and Delaware Group PM. We specialize in full-service property management services in the Eastern Shore. We can tailor our services to ensure you get the highest level of service. Get in touch to learn more!
