Owning a rental property provides more than an income stream. It also allows you to save money on your federal income taxes by taking depreciation. Essentially, the United States government lets you operate under the assumption that your asset loses value each year, whether it actually does or not.
It’s a powerful benefit of owning a rental property, but to maximize the benefits you get from depreciation, you have to understand how it works. That sounds like it would be easy, but is anything involving the Internal Revenue Service (IRS) ever truly easy?
How do you calculate depreciation?
Depreciation allows you to spread the tax benefit of qualifying expenses over the lifetime of whatever improvement you’ve made. When you file your taxes, rent and expenses get entered on a Schedule E form. If you had a gain or a loss, that gets carried over to your 1040.
Many expenses are of the single-year variety. An expense like snow removal or power washing the property counts as a single-year expense and you record the full value at one time.
In contrast, redoing your bathroom or putting in new floors count as expenses that can be depreciated. That means if your new bathroom costs $30,000 (it’s a really nice bathroom) and it has an expected lifespan of 15 years, then you can take $2,000 per year as an expense.
It’s a simple math problem to calculate depreciation. You take the value of the item (or the property itself as you will learn below) and divide its value by the number of years in its reasonable lifespan. Then you have the amount you can write off on your taxes as an expense each year.
When it comes to rental property, the biggest asset is the house, condo, or townhome itself. You can take depreciation on your rental property and there’s a formula for that too.
First, you need to determine the value of your property. And to make things more complicated, you have to separate out the value of building from the value of the land. You can depreciate the home, since it, in theory, has a value that gets used up over time, but you can’t take depreciation on the value of the land (since even if the house crumbles, the land will still be there).
Determining value can be done a number of different ways. You can use an appraisal, an insurance agent’s estimate, or a tax assessor’s report to set the value of your rental property. Those numbers may not be the same, but all of them are considered viable when determining your property’s value for depreciation purposes.
When it comes to a property, the IRS has set 27.5 years of useful life as the depreciation period for residential real estate. That means if you have a property worth $200,000 you can deduct $7,272.72 per year as an expense.
You can take depreciation on anything that contributes to the long-term value of your rental property. Fixing a sink that’s clogged, for example, is an expense that must be fully deducted in the year it happens. Replacing the sink, however, counts as a longer-term improvement and it can be depreciated over the life of the sink.