When you own an investment property such as a rental house, it's important to understand how depreciation works to maximize returns. The accelerated cost recovery system allows you to depreciate rental property at a faster rate over its determinable useful life, helping to lower both taxable income and rental expenses.
Both personal property and real property within the rental house can be depreciated if they contribute to generating income. You can calculate the depreciation based on the fair market value of the property when you place it in service, which helps property owners manage costs and improve the profitability of their rental property.
Depreciation allows property owners to recover the cost of income-producing property through annual deductions. This article breaks down how rental property depreciation works and its significance for real estate investors.
Understanding Depreciation
Depreciation refers to the gradual reduction in the value of a rental property over time due to wear and tear, aging, or obsolescence. The Internal Revenue Service (IRS) allows property investors to claim depreciation on income-producing properties as a tax deduction. This can significantly reduce your taxable income, providing tax savings over the lifespan of the property.
Depreciation Methods for Rental Property
The IRS provides two main systems for calculating depreciation: the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). Most residential rental property uses the GDS, which usually follows the straight-line depreciation method. This means the property’s value depreciates equally over its useful life, typically 27.5 years for residential rental properties and 39 years for commercial properties.
For certain scenarios, such as tax-exempt use or use of tax-exempt bonds, the ADS must be applied. It often results in a longer recovery period, extending the time for depreciation deductions but lowering the annual deduction.
Calculating Depreciation
To calculate depreciation on a rental property, you must first determine its cost basis, which includes the purchase price, closing costs, and certain capital expenses like legal fees and recording fees. From this, you subtract the land value and certain land preparation costs since land does not depreciate. The remaining amount is the depreciable property or the building value, and this adjusted cost basis is used to calculate annual depreciation.
Once the property is placed in service, you can begin claiming the depreciation. Using the straight-line method under GDS, you calculate annual depreciation by dividing the adjusted cost basis by the recovery period, such as 27.5 years for a residential property.
Tax Benefits of Depreciation
Depreciation reduces your taxable income by allowing you to deduct a portion of your property’s value annually. These yearly tax deductions help offset rental income, lowering your overall tax liability. Moreover, depreciation can protect you from the net investment income tax and decrease ordinary income.
However, property investors should be aware of depreciation recapture. When you sell a property, the IRS requires you to repay some of the tax benefits received from depreciation, which could increase your capital gains taxes.
Maximizing Depreciation Benefits
To maximize your tax savings, have your property manager find a tax professional who can help you determine the right depreciation method and ensure you claim depreciation correctly. They can help manage complex factors like capital improvements, income-producing activity, fire insurance premiums, and capital gains taxes.
Understanding real estate depreciation and its impact on your rental property’s value is essential for effective property ownership and investment. By leveraging depreciation deductions, you can reduce your tax bill, enhance rental real estate’s profitability, and optimize your long-term financial returns.
Summary
By strategically using rental property depreciation, you can lower your taxable income, reduce rental expenses, and increase your investment property's profitability. This powerful tool lets you manage costs while enhancing the long-term value of your real estate, making it essential for any savvy property investor aiming to generate income and maximize tax savings.
Partner with us at DeSantis Property Management to unlock the full potential of your rental property. With expert management and strategic use of depreciation and tax benefits, we’ll help you maximize profitability, reduce expenses, and grow the value of your investment. Let us handle the details so you can enjoy the rewards—call us today and take the next step toward real estate success.
