How does depreciation work?
Depreciation isn’t a fixed number. In year one, you'll be able to depreciate 3.636% of the original cost basis of the property and any qualified improvements. That number may change in future years as you make new improvements.
Let's take a look at an example. You buy a house for $100,000. Five years later, you pay $8,000 for a new roof.
Here's what your depreciation would look like through the first five years:
- Year 1: $3,636.36 (this is 3.636% of $100,000).
- Year 2: $3,636.36.
- Year 3: $3,636.36.
- Year 4: $3,636.36.
- Year 5: $3,927.26 (the depreciation deduction on the house plus 3.636% of the $8,000 roof).
You can use this new number, $3,927.26, until you accrue another depreciable expense or until the original 27.5 years of the house's depreciation schedule has run out. At this point, the new roof will still have four years go to, and you can deduct $290.90 from your taxes each year until it runs out.
To make this even more complicated, not all improvements have the same depreciation timetable. The IRS has a table that shows the period of depreciation for various expenses.
A new fence, for example, has a 15-year depreciation period, while office furniture depreciates over seven years. New roofs and a kitchen overhaul, however, have the full 27.5 years. Of course, a new stove in the kitchen wouldn't. You can see why record keeping is important and why you may need a good accountant.
It’s very important to keep very good records if you plan to depreciate hard items or improvements in addition to the value of the property. It’s best to have receipts and contracts along with before-and-after pictures. If the IRS has questions, it’s vital to have full documentation.
The process for depreciating a rental property placed into service after 1986 is called the Modified Accelerated Cost Recovery System (MACRS). Within that, there are two systems for depreciating your property:
- The General Depreciation System (GDS) is used in most cases.
- The Alternative Depreciation System (ADS) is generally only used if you’re legally required to. If your property is used for business 50% of the time or less, if it has a tax-exempt use, if it’s financed by tax-exempt bonds, or if it’s used primarily in farming, you may use the ADS.
A GDS property is depreciated over the 27.5-year period covered above. An ADS property is depreciated over 30 years if it was put into service in 2018 or later or 40 years if it was placed into use before that.
In most cases, you'll use GDS and the formulas above apply.
It’s also worth noting that you don’t stop taking depreciation when a property has been temporarily vacant. If, for example, you take the property off the market while you make repairs after a tenant leaves, you can still take depreciation.
The depreciation period ends when you either take the property out of use (by selling it or converting it to a personal-use property) or you've depreciated the full value. For accounting purposes, you have to take any depreciation you could have taken. Even if you didn't claim it, the IRS still knows about the depreciable value. And you can't retroactively claim depreciation.