Most of us are already familiar with how real estate investors earn grand rental income and net worth but pay nearly nothing in taxes. If you’re a real estate investor who owns a rental property and looking for ways to minimize the amount of tax you pay, maximizing your tax deductions with depreciation on your assets is one of the ways to do it.
Here are some of the reasons why rental property depreciation expenses can reduce taxes and help you to keep more money in the bank.
Understanding How Real Estate Depreciation Work
Rental property depreciation gives real estate investors to acquire tax deductions for their property. To do this, you as the owner should convince the IRS that the property in questions has the capability of having a useful life.
If the useful life of your property is determined, you can now utilize a formula to compute the amount of value lost due to depreciation every year and claim the deduction on your taxes.
Take note that as we discuss with you the basics of tax depreciation on real estate, it’s recommended that you ask a credible tax advisor if you have any questions on your specific situation.
Requirements for a Property to be Depreciable
You may depreciate a rental property if you can meet all of the requirements below (according to the IRS):
- You are the owner of the (even if the property is subject to a debt).
- The property is being used for your business or has an income-producing activity.
- Your property is considered to have a “useful life” meaning it can wear out, used up, decay, turn to be obsolete, or lose its value due to the results of natural causes.
- The property is expected to have a useful life for more than one year.
It’s important to know that even if the property achieves all of the above requirements, you cannot depreciate it if you put it in service and dispose of it or if the property is no longer used for running your business in the same year.
Be aware that land will not be considered depreciable if it never gets “used up”. Commonly, you cannot depreciate the expenses of landscaping, clearing, and planting since those activities are considered as part of the cost of the land and not buildings.
Most Common Rules for Depreciating Rental Property
There are some parts of a rental property that can’t be depreciated. For instance, if the value of the lot or land doesn’t wear out, it won’t be entitled to depreciation.
Expenses for routine operations like property management fees, regular maintenance, and property tax can’t be depreciated also. Rather, these expenses will be deducted from gross rental income in the year they happen.
According to the IRS Publication 527: there are several criteria that need to be met to be able to depreciate rental property:
- You own the property
- Property is generating incoming usually coming from tenants
- Property has determinable useful life (land won’t be qualified if it’s never used up)
- Property should have a useful life of more than one year
If you’re the type of investors who fix-and-flip properties, you can’t depreciate your property because it didn’t get the chance to be held less than one year.
Wholesalers are not also entitled to a depreciation deduction also since they never take real ownership of the real estate they’re wholesaling.
Steps for Calculating Rental Property Depreciation
If you’re calculating property depreciation, there is a three main step process you need to follow to determine the cost basis, dividing by the property’s useful life under the depreciation system you’ve chosen and calculated a depreciation schedule.
Identifying Your Cost Basis
The cost basis, which is the initial value from which any future depreciation is acquired is reliant on the value of your property and even certain qualified closing expenses.
If you’re purchasing the property as an investment property, the property value will most likely be the purchase price. Meanwhile, if you’re converting the property into a rental after living there for a while, your most ideal bet is to obtain a professional real estate appraisal.
For the calculation of the cost basis of a property, the value of land won’t be included, so don’t forget to include only the value of the house for tax purposes.
Divide it By the Property’s Useful Life
To calculate the annual amount of depreciation on a property, you need to divide the cost basis by the property’s useful life.
Calculate the Depreciation Schedule
Well, it’s not really easy to calculate and depreciate. It’s not that simple and there’s a reason for it. Why? In the first year, you have the property, you can only claim depreciation for as long as the property has been in use and service. Thus, if you begin renting the property in June, you need to pretend that you started renting in the middle of the month.
