How Does Rental Property Depreciation Work?
Last updated on 2021/5/9
Rental Property Depreciation: Let’s Talk Terms
Rental property owners use rental property depreciation as an important tool for deducting the costs of improving or buying a property during its useful life, which also lowers taxable income.
“Rental property,” for our purposes, is any building or housing you own, along with the land, but don’t personally occupy. Instead, you rent it to others rent it to others to work or live in. In this particular article, we’re going to primarily be talking about residential property – houses, duplexes, or other units you own but lease to others as a source of income. Most of the principles and processes discussed apply to other sorts of rental property as well, sometimes with minor differences.
“Depreciation” refers to a gradual reduction in value of something you own over time, often due to normal wear and tear or the natural aging process. “Depreciation” is almost always used in a financial sense. Most of the time, when someone brings up “depreciation,” words like “deduct,” “schedule,” and of course, “taxes” aren’t far behind. While losing value can be bad, documenting that depreciation can be good – especially when it's tax time.
Let’s see if we can gain a better appreciation for depreciation.
Depreciating Assets Basics
Most small businesses have “assets” of some sort. An asset is any property, equipment, or other resource that can be legally owned and controlled in order to produce or increase value. Factory machinery is an asset, as are computers and servers and inventory and owned property.
In the most general sense, assets can even be intangible – name recognition, positive branding, patents, copyrights, customer databases, warm fuzzy feelings, etc. – but you can’t directly buy most of those things with a company check. While they contribute to your ability to generate income, they have low liquidity – you can’t quickly or easily convert them into cash. Intangibles are thus not depreciable when you do your small business or personal taxes.
Rental property, on the other hand, is very tangible. It’s also relatively easy to assess the value or cost of the property and establish a depreciation schedule to utilize for tax purposes. Some of the expenses related to owning rental property can be treated as standard deductions, taken 100% in the year they were paid – property taxes, repair and maintenance of the property, insurance, or even travel related to property management. Other expenses, like the property itself, make more sense to spread out over time. If you’re already following a depreciation schedule for the property itself, sometimes it makes more sense to simply include those other miscellaneous costs in the total.
The accury store is the place to be.
Two Ways to Use Rental Property Depreciation
There are two basic ways a business (even if that business is just you and the two or three rental homes you own and maintain) can deduct the cost of rental property, equipment, or other tangible assets.
The first is the same way you used to be able to take various deductions on your personal tax return – you save your documentation, and subtract any allowable expenses from your gross income the year, thus lowering your tax obligations by lowering your taxable income for that year. That makes sense for deductions on your personal tax returns, or for relatively normal business expenses. For major expenses, however, which contribute to the business over a longer period of time, there’s a better way.
That brings us to the second way businesses (including you acting as a landlord or manager) can deduct expenses – establish a depreciation schedule. A depreciation schedule requires a reliable estimate as to the useful life of the asset in question. For example…
Let’s assume your business is heavy on communication – phones, social media accounts, online chat help, etc. – and you have a dozen computers tied into your fancy phone system, along with headsets, external backups, dedicated servers, etc. Just to keep the math simple, we’ll also assume you purchased everything in the same tax year for a nice round total of $20,000 in the year 2020, and that according to industry experts (or the manufacturers themselves), the equipment is reliably for ten years.
Rather than deduct $20,000 from your 2020 tax returns, you’ll deduct $2,000 each year for ten years. This spreads out the benefit to you while still securing your full deduction.
“Cost Basis” and Rental Property Depreciation
When you depreciate rental property, the basic set-up is the same. As you might imagine, however, the proverbial devil is in the details.
First, you’ll need to determine your “cost basis.” At its most basic, this is the value of the property as a whole MINUS the value of the land on which it sits. Land, in the eyes of the IRS, is not depreciable – it doesn’t “wear out” or get “used up.” While it’s sale price may rise or fall over time, the land itself doesn’t have a natural deterioration schedule the way manmade buildings or machinery do.
If you’re uncertain how much of the total value is land and how much is the property upon it, take a look at the numbers used in the most recent tax assessment. They’re generally broken down into the appropriate categories, and even if you have reason to believe the overall value has changed since the property was assessed, you’ll at least have the percentages. (If the assessment shows a total property value of $250,000, of which $50,000 is the value of the land itself, that means a rough breakdown of 20% land value + 80% constructed value. If you’ve more recently computed a total value of $300,000, the same proportions would give you a constructed value – our “cost basis” – of $240,000.)
Cost basis quickly gets more complicated than that however, although generally to your benefit. If you paid for a property survey prior to purchasing the property, for example, or incurred legal expenses in the process, or had any other miscellaneous expenses and fees directly related to acquiring the property, they can usually be added to your cost basis. There’s also the possibility of modifications to your cost basis over time – when you make improvements or hook up new utilities, or when the property is damaged due to a storm or natural disaster, for example. Your “adjusted basis” changes the math from year to year.
This is probably a good point to mention that if you own rental property and hope to make full use of rental property depreciation, you should seriously consider utilizing a tax professional proficient in this type of thing. It’s one thing for us to cover the basics and familiarize ourselves with some of the terminology; it’s another to master the minutia of the tax code in the most profitable way possible.
It’s usually worth the extra time and care to handle rental property depreciation properly. Depreciation allows you to take ongoing tax deductions on what is in many ways a theoretical expense. The rental homes you purchased ten years ago, for example, and from which you currently draw an income (by renting them to others), are still earning you an annual deduction, dramatically reducing your tax burden on this new income.
Why do so many determined individuals go to all the headache and expense of acquiring, repairing, and managing their own rental properties? Because rental income often has the lowest effective tax rate of any traditional income source. It’s even possible to show a loss on your tax returns, despite making substantial profits each year – all legal, all above-board. It’s just the way the tax code is currently structured. And it’s largely anchored in the power of rental property depreciation.
What Are The Requirements to Deduct Rental Property Depreciation?
The IRS is very specific about its requirements for rental property depreciation:
- You must own the property in question (you can’t be renting and then subleasing it).
- You use the property as part of your business or you rent it out to others as a source of income.
- You keep it for at least a year. (You can’t depreciate the value of property you buy and ‘flip’ right away.)
That’s pretty much it. The other requirements for depreciable assets don’t really apply to real estate:
The property is expected to last more than one year. (If your rental housing or commercial real estate won’t make it a year, you have bigger problems than potential tax deductions.)
The property has a “determinable useful life” – it’s possible to estimate with some accuracy how long it’s likely to be usable before it decays or wears out.
This last one could be tricky with rental property, but the IRS has taken this particular calculation out of your hands – which is oddly something of a blessing.
All residential rental property has a usable life of 27.5 years for tax purposes. Commercial property has a life of 39 years. We could go into how and why the powers-that-be arrived at these magical numbers, but like most things related to paying taxes, it doesn’t really matter. That’s just what they are.
Let’s use another overly-simplified example to see what this means in practice. You own rental properties with a total cost basis of $100,000, all purchased in January of 2020 (so we have the full calendar year to work with). They’ll gradually depreciate over a period of exactly 27.5 years without any adjustments (which is unrealistic, but we’re keeping things simple for now). That means a depreciation schedule of 3.636% per year until the total reaches zero in June of 2046 (2020 was year one, 2021 was year two, 2022 was year three, etc., so 2046 is year 27 and June/July is halfway through the calendar year.)
Those numbers – 27.5 years and 3.636% per year – are fixed amounts, at least for now. Like “pi” (3.1415927…) or “e” (2.71828…), for our purposes they are mathematical constants. We need only plug-n-play our own actual dollar amounts to get a pretty good idea of our own rental property depreciation.
Other Terms You May Encounter
It’s impossible to learn everything there is to know about rental property depreciation in a single post, but hopefully this has given you a basic overview of the process and its possible benefits to you. Before we wind down, however, there are a few other fancy terms you might come across if you choose to continue learning more about the subject.
This is the formal accounting term for everything we’ve been talking about. All residential rental property is depreciated using this accounting technique – 3.636% per year for 27.5 years. (The exception is any which may have been grandfathered in under some other method prior to 1986.)
Most properties you might buy for purposes of renting them out will fall under “GDS.” The “ADS” category is for certain situations in which the property has a committed, tax-exempt use or purpose, is financed by tax-exempt bonds, is used primarily for farming, or a handful of other specific circumstances. In short, if you have to ask what it means, it probably doesn’t apply in your case.
Remember above when I said that sometimes you can deduct expenses immediately and other times it makes more sense to “roll them in” to your total expenses as part of your overall rental property depreciation schedule, spread across 27.5 years? It turns out there’s a third way – “cross segregation.”
The IRS will allow you to depreciate individual items over a shorter time period, giving you a greater deduction more quickly in exchange for a lower deduction over time. Computers, business vehicles, and appliances, for example, can be depreciated over a five-year period. Office furniture? Seven years. Fencing or roads you build specifically as part of your property? Fifteen years. You get the idea.
It’s pretty complicated to keep it all straight and it means a lot more paperwork, but it’s an option.
This is a method of reducing or avoiding capital gains taxes if and when you choose to sell your rental property. If you sell a home you’re renting out for a profit, and quickly use that profit to invest in another property instead of pocketing the money, a 1031 Exchange allows you to defer paying a capital gains tax until you sell the newer property. Of course, you can simply do the same thing again with the next one, and so on, and so forth….
In practice it’s usually more complicated than that, but if you come across the term while studying up on rental property depreciation, you’ll at least know what it means.
You probably already know how much the IRS loves forms and paperwork. The Schedule E is the one you use to report income (or losses) from a number of different things, including – you guessed it – any rental properties you may own.
It looks a bit daunting at first glance, but it’s actually rather straightforward. It also gives you the opportunity to claim any number of deductions related to your rental property, including…
- Advertising
- Auto and Travel
- Cleaning and Maintenance
- Commissions (of agents who help you rent the property out)
- Insurance
- Legal and Other Professional Fees
- Management Fees
- Mortgage Interest Paid to Banks, etc.
- Other interest
- Repairs
- Supplies
- Taxes
- Utilities
- Depreciation Expense
This one comes up a lot in discussions about rental property depreciation, probably because so many people ignore the advice to secure the aid of a tax professional before diving in. They realize after the fact that they’ve messed up, or at least overlooked multiple ways to save themselves serious money on their taxes in relation to their rental property.
That’s where the 1040-X comes in. It’s the “oops!” form that allows you to amend previous submissions.
Conclusion
I hope some of this was helpful for those of you considering renting as a way to generate income. It’s a big commitment – not nearly as easy as it sounds – but the payoff can certainly be worth it if you have the skills and temperament.
And as always, let us know if you we can be of any assistance along the way.