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U.S. tax law provides for a depreciation schedule that allows property owners to deduct the expenses of building and maintaining rental properties, as well as build-out costs such as furniture purchases over time. When it comes time to sell your rental property, you can use those deductions up to certain limits on your taxable income which you must report in order to pay taxes on earnings or capital gains made during that year. If the cost basis is higher than what was originally paid by selling at its current market value then an additional amount will be taxed
Depreciation of rental property is a method used by real estate investors to subtract the expenses of acquiring and maintaining an investment property. Rental property depreciation takes place during the period of the property’s useful life, as assessed by the IRS’ depreciation method. This is significant for investors since depreciation on rental properties helps optimize tax savings.
How Does Depreciation Work in Residential Rental Properties?
Depreciation on residential rental property is a capital expenditure, which means it helps you recoup the expenses of purchasing and improving your rental property. Depreciation is the most common tax benefit accessible to real estate investors, and it may help them enhance their cash flow by lowering their tax liability. This implies you may cut your taxable income each year without affecting your cash flow.
The modified accelerated cost recovery scheme is the standard technique of depreciation in the United States (MACRS). The capitalized cost basis of property is recovered over a defined life by yearly depreciation deductions under this arrangement. The general depreciation system (GDS) and the alternative depreciation system (ADS) are the two forms of MACRS (ADS). We’ll utilize GDS throughout the study since it’s the most prevalent system, whereas ADS is less frequent.
Depreciation on a rental property is assessed over a period of 27.5 years for residential properties and 39 years for commercial properties. The IRS considers these to be the useful lifetimes of both kinds of properties. Keep in mind that depreciation on real estate starts when the property is put into service, which is when you rent it out rather than when you buy it. When you sell the property or take it out of service, such as when you elect to utilize it as your main house, depreciation stops.
Rental property depreciation covers substantial repairs that are capitalized, but it cannot be used to offset the cost of typical wear and tear. It only covers purchases and improvements, and the boundary between what counts as an improvement and what counts as a repair is sometimes blurry. If you’re unsure if something is an improvement or a repair, talk to your tax expert.
Repairing a few shingles on your roof, for example, is considered a repair and is not depreciated. As a result, rather than depreciating the cost of the repairs, you may expense the whole amount. If you need to replace the whole roof, on the other hand, you would depreciate it over the roof’s useful life, which is 27.5 years, the same as the property to which it is connected, as defined by the IRS’ depreciation schedule, since replacing the roof is not a repair but an improvement.
The useful lives of common assets are used to calculate rental property depreciation:
- Appliances, carpeting & furniture: 5 years
- Office furniture & equipment: 7 years
- Fences & roads: 15 years
- Residential rental buildings, structures, furnaces & water pipes: 27.5 years
- Buildings: 39 years
What Are the Depreciable Assets?
The IRS decides which properties are eligible for depreciation. Land, landscaping, and a principal dwelling, for example, are not depreciable. You can’t put a property in operation and sell it the same year you depreciate it in order for real estate depreciation to apply. This implies you can’t rent a home out in January, sell it in April, and claim depreciation in the same year.
Depreciable properties are those that fall under at least one of the following categories:
- A rental property that was put into service after 1986, which indicates it was utilized as a rental property after 1986 and is unique to the sort of depreciation method you’re employing (we use the GDS method).
- A rental property that is projected to provide money for more than a year, as is the case with most income-producing properties.
- Residential real estate is utilized to generate revenue.
- Commercial real estate that is owned and occupied by you, such as a building where you run your company.
- Commercial real estate that generates income, such as an office building or a retail mall
- Buildings having two or more distinct apartments, such as a duplex or triplex, are examples of multifamily dwellings.
Depreciation Method for Rental Properties
The IRS expects you to observe particular depreciation guidelines when it comes to rental property. The MACRS, which distributes expenses and depreciation deductions across 27.5 years for residential assets and 39 years for commercial properties, is one of them. Keep in mind that we’re utilizing the MACRS GDS rather than the ADS.
Let’s take a look at the MACRS formula, which is the asset’s cost base multiplied by the depreciation rate. The cost basis is the same as the property’s acquisition price. One of the three tables provided by the IRS in Publication 946 might help you choose which depreciation rate to utilize.
MACRS Formula using GDS = Asset cost basis x Depreciation rate
Let’s look at an example of the MACRS formula in action.
According to the IRS, any residential rental property put in operation after 1986 is depreciated over its useful life. Although the MACRS calculation is straightforward, we recommend that you calculate MACRS with the help of a tax expert since the depreciation rate used changes based on the kind of asset being depreciated.
Although MACRS is utilized for real estate, other improvements are normally depreciated using the straight-line technique. This implies that goods like a new roof, windows, doors, plumbing systems, and so on may be depreciated and deducted over time.
Depreciation Schedule for Rental Properties
A Depreciation Schedule for Rental Properties helps you value your assets, calculate your depreciation expenses, and calculate your capital expenses. A Depreciation Schedule for Rental Properties shows what kind of depreciation you can take and deduct each year. It shows the breakdown of the land value and the building value because you can only depreciate the building value. It’s based on the useful lifespan allowed by the IRS for the property type.
A Depreciation Schedule for Rental Properties generally includes the:
- The sort of property you’re depreciating: On property, for example, buildings and structures, office equipment, machinery, furniture, or cars
- For example, whether you’re utilizing the more typical GDS approach or an alternate method of depreciation (ADS)
- Cumulative depreciation to date: This is the amount that the asset has depreciated since it was first placed into operation till now.
- Future depreciation projection: This is a forecast of how much depreciation the asset will experience over a certain period of time.
Depreciation of Rental Property Reporting
You need to know where to record rental property depreciation now that you understand what it is and how it works, particularly if you’re doing your own taxes. Although we suggest consulting with a tax expert, knowing where to declare rental property depreciation on your tax paperwork may be useful.
Here are three procedures for reporting depreciation on a residential rental property.
1. Keep track of your income and expenses on a Schedule E.
Typically, you will get a 1040 federal income tax return, and you will enter all of your rental property income and costs on Schedule E. In most cases, your accountant will assist you in completing this form.
2. Calculate your net profit or loss.
After completing Schedule E, determine whether you experienced a net gain or loss and note the amount on the 1040 form. Rental property depreciation is one of the key costs that should be included in your Schedule E. This is where you depreciate costs that have a longer than one-year useful life.
On a rental property, you’ll often need to deduct the following expenses:
- New roof
- Changing out a bathroom
- Changing out a kitchen
To discount these expenditures, apply the following formula:
- Divide the item’s total cost by the improvement’s useful life.
The expenditure is then written as a fraction. For instance, if you invest $15,000 on a driveway that will last 15 years, split $15,000 by 15 to obtain $1,000. This implies you may deduct $1,000 every year for the life of the driveway.
3. Depreciate the property you bought.
When you buy the property, which is generally your greatest real estate-related cost, you may do the same thing as in step 2. However, since a residential rental property building has a useful life of 27.5 years and land cannot be depreciated, you must deduct the land cost from the overall property cost.
Consider the following scenario:
You spend $300,000 on a property. The land is worth $125,000, and we already know that residential construction has a useful life of 27.5 years, according to the IRS. Let’s now calculate how much the building is worth on its own. We obtain $175,000 by subtracting the land cost from the overall property cost.
$175,000 ($300,000 – $125,000)
Now that we know the structure is worth $175,000 and that we want to depreciate it over 27.5 years, we divide $175,000 by 27.5 to obtain $6,363.64.
$6,363.64 = $175,000 / 27.5
This is the amount you may deduct from the purchase price of your investment property each year as depreciation. This lowers your tax bill by $6,363.64 per year while maintaining the same cash flow. Essentially, you’re moving your cost base downward by the amount of depreciation absorbed each year.
Recapture of Rental Property Depreciation
Recapture of Rental Property Depreciation is the gain that the real estate investor receives from selling the investment property, and it must be reported as income to the IRS. This can hurt an investor because it’s additional income that you have to pay taxes on based on your ordinary tax rate, which can be in addition to capital gains tax. Depreciation of rental property should be reported on IRS Form 4797.
When you accept depreciation, you’re lowering the cost basis of the property. So, when you sell the property, you’ll have to pay taxes on it since you used depreciation to offset part of your regular income taxes. When the property’s sales price exceeds its adjusted cost basis, depreciation recapture is applied. An adjusted cost basis is just the asset’s net cost after depreciation has been taken into account. In six phases, we’ll go through this in further depth.
Keep in mind that if you sell an investment property for more than you paid for it, you’ll have to pay capital gains tax. A portion of the profit is treated as a capital gain and may be eligible for the capital gains tax rate of 20%, while the remainder is taxed at the regular tax rate, which is normally higher than the capital gains tax rate.
Part of the profit is taxed at the ordinary tax rate because it was depreciated over time. This can get complicated, so we suggest consulting with a tax professional. The IRS uses Recapture of Rental Property Depreciation as a way to collect taxes on profits from the sale of a rental property. This is because the taxpayer was able to previously write depreciation off against their taxable income during their ownership of the property.
Residential Recapture of Rental Property Depreciation Example
We’ll teach you how to calculate depreciation recapture in six simple steps. To begin, we must determine the property’s tax basis, which is equal to the purchase price plus any closing fees and capitalized expenditures. The adjusted cost basis, which is the purchase price less yearly depreciation multiplied by the number of years of ownership, is also required.
Now, let’s look at a Recapture of Rental Property Depreciation example in six steps.
1. Invest in a rental property.
Let’s pretend Jane paid $350,000 for a residential income-producing property. Let’s say the property depreciates at a rate of $20,000 per year, and Jane chooses to sell it for $430,000 after 11 years.
2. Determine the Rental Property’s Adjusted Cost Basis.
The adjusted cost basis is calculated by subtracting the purchase price from the yearly depreciation rate multiplied by the number of years of ownership, which is $130,000.
$130,000 = $350,000 – ($20,000 x 11)
3. Determine the Rental Property’s Realized Gain
The realized gain on the property is then calculated by deducting $130,000 from $430,000, yielding $300,000.
4. Calculate the Rental Property’s Capital Gains
The capital gain will be $300,000 – ($20,000 x 11), or $80,000, resulting in a recapture gain of $20,000 x 11, or $220,000.
5. Be Aware of Your Tax Brackets
Let’s pretend there’s a 20% capital gains tax and a 28% income tax rate. Jane will pay a total of $16,000 + $61,600 = $77,600 in taxes on the rental property (0.20 x $80,000) + (0.28 x $220,000).
6. Determine the Amount of Depreciation Recapture
The depreciation recapture amount is 0.28 x $220,000, which is your tax bracket multiplied by the recapture gain in percentages.
The amount of depreciation recovery will be $61,600.
As you can see from the example above, it’s fairly difficult, but you managed to figure out the amount of depreciation recapture. So, now that you know how much you’ll get when you sell a house, you can determine if it’s worth selling and how much you need to get for it.
Now, let’s look at the perspectives of a few real estate professionals on depreciation recovery.
“This is the depreciation recapture tax, and it’s intended to ensure that you pay the government back approximately what you saved in taxes over the years.” Remember that depreciation protected you from paying ordinary income tax rates, which are now up to 37 percent.”
— Domenick Tiziano, Accidental Rental’s Owner
“Depreciation recapture typically applies to upgraded real estate since the actual estate will gain in value over time while the improvements will depreciate with time and usage. Any gain will be calculated using the recomputed basis. If there is a profit, it will be taxed as capital gain, and if there is a loss, the taxpayer will be able to claim it as a loss.”
— Brenda Di Bari, Halstead Real Estate Commercial Real Estate Broker
Commonly Asked Questions (FAQs)
What Is the Rental Property Depreciation Method?
MACRS is the depreciation technique used for rental property. ADS and GDS are the two forms of MACRS. GDS is the most typical technique for spreading depreciation of rental property throughout its useful life, which is 27.5 years for a residential property according to the IRS.
When you sell a piece of real estate, what happens to the depreciation?
If you sell your rental property for more than its depreciated value, you will normally have to pay a depreciation recapture tax. On the depreciation amount that you claimed, the depreciation recapture tax is normally 20% plus the state income tax. The actual amount, however, is determined by your tax bracket.
You may wish to explore a 1031 exchange if you want to avoid paying the depreciation recapture tax. Read our in-depth information on section 1031 exchanges to learn more about a 1031 exchange.
Do You Have to Take Depreciation on Your Real Estate?
You are not required to include depreciation in your calculations. However, you should do so since it is one of the most common rental property tax deductions. Also, the IRS expects you to accept depreciation, so whether or not you do, you’ll have to pay a depreciation recapture tax when you sell the property.
Final Thoughts
Real estate depreciation is a method of deferring the expenses of your rental property and lowering your tax burden over time. The IRS determines real estate depreciation depending on the kind of property and its useful life. The IRS uses a 27.5-year depreciation schedule for residential real estate and a 39-year depreciation schedule for commercial real estate.
