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What is depreciation?
In simple terms, there are two ways businesses can deduct the cost of assets they buy. The cost of smaller and non-durable items, such as repairs or money spent on office supplies, is generally deducted all at once. On the other hand, the cost of assets that have a useful life of one year or more can be deducted over a longer period of time. This is known as depreciation.
To depreciate an asset, it needs to have a quantifiable useful life. Let’s say a business buys a piece of machinery for $10,000. This item can be reasonably expected to last for 10 years. So the business can deduct $1,000 of this cost each year for 10 years.
Some assets (including rental properties) have IRS-determined useful life spans that we’ll get into later. Depreciation allows capital expenditures to lower the business’ taxable income for a number of years. That’s particularly helpful to rental real estate businesses.
How does rental property depreciation work?
If you buy a property with the intention of renting it, you can depreciate the cost of acquiring the property over a period of time.
There’s obviously no one-size-fits-all useful life when it comes to rental properties. Some cheaply built homes are worn out after a decade or so. Some historic homes have been around for 100 years or more and are still in perfectly rentable shape.
So the IRS provides guidelines when it comes to the depreciation of real estate. Most real estate investors buy residential rental properties. The IRS says you can treat these as having a useful life of 27.5 years. In other words, you can divide your cost basis in the property by 27.5 to determine your annual depreciation "expense." If you own a commercial property, the depreciation period is 39 years.
Another important concept is that only the value of the building itself can be depreciated. Not the land that it’s built on. Buildings have a useful lifespan, but land does not. Land will never be "used up."
There are a few acceptable ways to determine the value of a building versus the land it’s on. You can have the property appraised by a qualified professional, for example. A tax assessment is another way to separate the value of land.
You can continue to depreciate a rental property over time until you sell the property or you’ve depreciated your entire cost basis.
What's your cost basis in a rental property?
You might think your cost basis is the amount of money you paid for a property. But it’s not always that simple.
The cost basis for rental real estate is your acquisition cost (including any mortgage debt you obtained) minus the value of the land it's built on. If you paid $200,000 for a duplex and the land is appraised for $50,000, your basic cost basis is $150,000.
However, there are some other costs that can be included in your cost basis. These include the following (but there are other applicable costs, as well):
- Any debts of the seller that you assume. For example, if you agree to assume a $5,000 loan that the seller owes, that would be added to your cost basis.
- Legal costs you incurred while acquiring a property.
- Recording fees.
- Property survey costs.
- Transfer taxes.
- Title insurance costs.
Your cost basis can also be adjusted over time -- this is your "adjusted basis." This includes the cost of improvements or additions you make to the property. It also includes expenses related to casualty damage or the cost of running utilities to the property.
Imagine that your original cost basis in a property is $200,000. You then spend $30,000 putting a new roof on it and $25,000 on renovations. Your adjusted cost basis for depreciation purposes is $255,000.
Can your rental property be depreciated?
In order to depreciate rental property, you have to meet the following criteria:
- You must own the property. You can’t rent a property, sublet it to someone else, and then claim a depreciation deduction.
- You must use the property to generate income. For real estate purposes, this typically means you rent it to tenants.
- You must be able to determine a useful life for the property. As we discussed in the previous section, residential real estate has an IRS-determined useful life of 27.5 years, while commercial real estate has a useful life of 39 years. This requirement is why land can’t be depreciated, as land is never "used up."
- The property must have a useful life of more than one year. This isn’t an issue with rental real estate, but for other capital expenditures, it gives a good guideline as far as what property can be depreciated and what should be expensed immediately. For example, a new range you install in a rental property can be reasonably expected to last for more than a year. A "for rent" sign that you buy and place in front of the property cannot, and should be treated as an immediately deductible expense.
Also, to depreciate a rental property, you should plan to hold it for more than a year. If you plan to buy a house, fix it up, and sell it a few months later (a "fix-and-flip"), you generally can’t depreciate the property during your holding period.
If you're unsure whether you should claim a depreciation expense on a property you held for a short time, consult a qualified tax professional.
How do you calculate depreciation?
If you own a rental property for an entire calendar year, calculating depreciation is straightforward. For residential properties, take your cost basis (or adjusted cost basis, if applicable) and divide it by 27.5.
Put another way, for each full year you own a rental property, you can depreciate 3.636% of your cost basis each year. If your cost basis in a rental property is $200,000, your annual depreciation expense is $7,273.
For a commercial property, divide your cost basis by 39. This gives you a 2.564% depreciation expense for each full year you own the property.
It's more complicated when you own the property for only part of a calendar year. This generally occurs in the years when you buy and sell a property. In these cases, you can prorate the depreciation based on how many months of the year you used the property to generate rental income.
The IRS provides the following table for use during the year you acquire a property:
|Month the Property Was Put Into Service||Cost Basis Percentage You Can Depreciate|
|Item||Annual Income (Cost)|
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