Learn about how you can reap the rewards of investing in the most tax-advantaged asset class in America.
Real estate is one of the most tax-advantaged types of investments you can make. The main reason is real estate depreciation.
Thanks to depreciation, most rental property owners pay tax on just a fraction of the rental income their properties generate -- if they pay anything at all.
There’s a lot that smart real estate investors should know about depreciation before buying their first investment property. Here’s a thorough guide for all rental property owners about this important topic.
What is real estate depreciation?
Real estate depreciation is the process of deducting the cost of acquiring an income-generating property over many years. It's one of the most important tax benefits of real estate. This depreciation works a bit differently from depreciating non-real-estate assets.
Let's break it down.
When you depreciate a business asset, you deduct its cost over an extended period instead of writing it off immediately.
In many cases, business owners can deduct expenses all at once. For example, if you attend an industry conference, you can deduct the costs of attending the conference on your next tax return. If you buy a case of paper for your printer, you can deduct it as an office supply expense.
On the other hand, when you buy a business asset that should last several years, it's typically depreciated, or deducted over time. For example, say you buy a laptop that has a useful life of five years (the IRS sets the "useful life" for each type of capital asset). You paid $1,000. You would deduct the cost over five years instead of deducting $1,000 on your next tax return.
If you own real estate to generate income (i.e., rental property), you can also depreciate that property. After all, being a rental property owner is a type of business, and the property is a business asset that should last for many years.
How real estate investors benefit from depreciation
Depreciation gives real estate investors a tax deduction that reduces their taxable rental income every year. This is a huge tax advantage of real estate investing as opposed to investing in most other asset classes. For example, you can’t depreciate the stocks you buy to help reduce your taxable dividend income.
Depreciation schedules for residential and commercial property
Real estate investors can depreciate the cost of the building (but not the land it’s on) over the useful life of the property. Since there’s no way of knowing how long a rental property will be usable, the IRS has standard depreciation periods. Residential properties have a useful life of 27.5 years, while commercial properties can be depreciated over 39 years.
We’ll go over the mathematics of figuring out the cost basis of your building in the next few sections, but here’s a quick example of how this works. Let’s say you buy a four-unit residential property for $300,000. You can take an annual depreciation deduction of $10,909 ($300,000 divided by 27.5) each year that you own the property. This reduces your taxable rental income and is one of the best benefits of real estate investing.
In fact, between deductible expenses and depreciation, it isn’t uncommon for a profitable rental property to show a loss for tax purposes.
What's your building's cost basis?
One of the most important concepts real estate investors should learn is that of cost basis and how it differs from the purchase price of an investment property.
First, cost basis is the net acquisition cost of an asset, not just the contract sale price. If you buy a property for $200,000 and you pay $5,000 in origination fees, legal costs, and other expenses, your cost basis would be $205,000.
Your cost basis also includes any capital improvements you make to the property. This includes anything that substantially increases the value of the property. If you put a new roof on a property, for example, or if you renovate a kitchen, it's a capital improvement. Capital improvements do not include routine maintenance or repairs that are necessary to keep the property in good working order. If you're unsure about an expense (there's a lot of gray area here), consult a tax professional who's experienced with real estate investing.
The land/building distinction is an important one to make, as well. You typically don’t buy the building and land in separate transactions, but you still need to separate the value of each for depreciation. There are a couple of ways you can determine how much of the purchase price to allocate to land:
- Use the market value from an appraiser as of the date of the sale. For example, if you pay $250,000 for a property and your appraisal values the land at $50,000, you can safely assume that the building is worth $200,000.
- Look at the property’s most recent tax assessment to determine the appropriate proportions. It’s worth noting that tax assessments aren't intended to reflect the actual market value of a property. However, they typically separate the land and building value, which can help you allocate your acquisition cost accordingly.
Depreciation affects your cost basis in a property
It’s important to know how real estate depreciation affects the cost basis of your investment. Specifically, as you take depreciation deductions over time, they reduce your cost basis.
For example, let’s say you own a residential property and the depreciable cost basis (your net cost of the building) is $200,000. This would give you a $7,273 annual depreciation expense. After one year of ownership, this would reduce your cost basis to $192,727. After two years, it would reduce your cost basis to $185,454. And after 27.5 years of ownership, your cost basis would effectively be reduced to zero unless you made capital improvements along the way.
Learn about how you can reap the rewards of investing in the most tax-advantaged asset class in America.
Real estate depreciation rules: Do you qualify?
To depreciate a business asset on your tax return, it needs to meet the following criteria:
- The asset must be owned by you. In other words, you can’t lease a property, sublet it to another tenant, and then claim a depreciation deduction. Remember, depreciation is based on the price you paid for something, not its value.
- The asset must be used to generate income. So fix-and-flips don’t count.
- The asset must have a useful life of more than one year. Where this comes into play for real estate investors is capital improvements and determining which should be added to the cost basis. For example, a new roof has a useful life of more than one year, so it's a depreciable asset. Lawn service doesn’t last for over a year before needing to be done again, so it isn’t depreciable.
- The asset must have a useful life that can be determined. In the case of real estate, this may sound like a difficult task. After all, who can really say how long a particular rental property will last? However, the IRS sets a useful lifespan of 27.5 years for residential real estate, regardless of how many years it’s actually used as a rental property.
Does the property have to be rented to qualify?
To depreciate an investment property, it needs to be available as a rental. You don’t need to have a tenant in place. If your property sits vacant between tenants for three months in a given year but was advertised by your property manager, you can still take a full year’s worth of depreciation because the property was available to rent all year.
Your property doesn’t even need to be tenant-ready at all times if you're working to make it so. For example, if you took it off the market to make repairs after a tenant moved out, you can still claim depreciation even though it wasn’t ready for tenants 100% of the time.
The main exclusion is investment property that you plan to quickly sell for a profit. If your main goal in owning a rental property is to sell it, not hold it as an income-generating investment, you cannot depreciate it. Fix-and-flips aren’t eligible.
Special depreciation rules for the first year you own the property
So far, we’ve only discussed full-year depreciation deductions. That's how it works most of the time. Two big exceptions are the year in which you buy a property and the year in which you sell it (or the year you’ll have depreciated your entire cost basis).
Recall that depreciation is spread over 27.5 years for residential rental properties, which means you get to depreciate 3.636% of the cost basis each year. In the year you acquire a property, the depreciation deduction is prorated -- even if you buy it just after the year begins. For the first year of investment property ownership, the IRS provides the following guidelines for calculating your depreciation deduction:
|Month the Property Was Acquired||First-Year Depreciation as a % of Cost Basis|
For example, let’s say I acquired a rental property in August 2019 with a building cost basis of $100,000. Based on the percentage in the chart above, I can take a depreciation deduction of $1,364 on my 2019 tax return to offset whatever rental income the property generated. In subsequent years, I can take the full depreciation amount, or $3,636.
If you sell a property, the depreciation is prorated in the opposite manner (largest percentage in December, smallest in January). And remember that your depreciation deductions end after your entire cost basis has been depreciated. For example, if I own an investment property with a $100,000 cost basis and I’ve already depreciated $99,000 over the years I’ve owned it, I can only use a $1,000 depreciation deduction for this year. Then I can no longer claim the benefit on my subsequent tax returns.
Depreciation recapture: How real estate depreciation affects you when you sell
Remember that real estate depreciation lowers your cost basis over time. This can have major tax implications when you eventually sell the property. Especially if you sell it for more than you paid for it.
Real estate depreciation, as we’ve seen, can dramatically reduce your taxable rental income every year. That’s why it’s such a great benefit for real estate investors.
However, there’s a big caveat. When you sell a depreciated rental property, the IRS wants this benefit back. This is a form of capital gains tax known as depreciation recapture. While real estate depreciation can be a rental property investor’s best friend, depreciation recapture can be their worst nightmare, especially if they've owned the property for a long time.
Here’s the general idea. When you sell a property, any capital gain -- the difference between the net sale price and your cost basis -- is divided into two parts. Any part that represents a gain over your original cost basis is a capital gain and is taxed at your capital gains tax rate.
Any portion of the sale proceeds that represents a gain over the depreciated cost basis (but not greater than the original cost basis) is depreciation income. That's taxed as depreciation recapture, which currently has a flat 25% rate.
It's also worth mentioning that this applies to the depreciation you were entitled to, whether you claimed it on your taxes or not. You can't forego your annual depreciation deductions and avoid paying depreciation recapture when you sell.
Technically, this applies to any depreciated asset you sell, but in practice, it only affects real estate, as it’s a special type of depreciable asset. Think of it this way -- if you buy a new computer for work and sell it four years later, you’re not likely to get anything close to what you paid. In fact, you’re not even likely to recoup your depreciated cost basis in the asset. On the other hand, real estate tends to increase in value over time.
An example of depreciation recapture
Let’s say you bought an investment property for a net cost (building) of $200,000 and that you’ve owned it for 10 years. You’d have claimed depreciation of $72,727 over your ownership period, which would bring your cost basis down to $127,273.
You now decide to sell the property for net proceeds of $300,000. Of this, $100,000 would be considered a long-term capital gain and would be taxable at your marginal long-term capital gains tax rate -- 0%, 15%, or 20%, depending on your taxable income. The $72,727 of cumulative depreciation would be taxed at a 25% rate. Assuming you’re in the 15% long-term capital gains tax bracket (it's most common), you’d be looking at a $33,182 tax bill on the sale of your property.
A 1031 exchange can help you avoid depreciation recapture
Depreciation recapture can result in a massive tax bill when you sell an investment property. Fortunately, there’s a way to get around it.
If you plan to use the proceeds from the sale of an investment property to buy another investment property, you can use a 1031 exchange to roll the tax liability into the new property’s cost basis. Be sure to check out our 1031 exchange guide if you want to learn more. For now, just know that as long as you keep your money invested in rental properties, you can theoretically defer taxation -- both capital gains and depreciation recapture -- as long as you want.
Calculating your depreciation deduction each year
It would be nice if you could take your cost basis in a rental property, divide it by 27.5, and deduct this amount forever. Unfortunately, it’s not that simple. For starters, you won’t get a full year’s depreciation deduction in the year you acquire the property. Furthermore, you’ll rarely hold a property for 27.5 years without it needing some sort of capital improvement.
With that in mind, consider the following situation:
You acquired a property in February 2019 and the net purchase price was $250,000. Based on your most recent tax assessment, the building makes up 80% of the property value, giving you an initial cost basis of $200,000. In 2021, you renovate the kitchen and bathrooms at a total cost of $40,000. You don’t plan on making any other capital improvements through at least 2023.
So, over the first five years of ownership, your depreciation deductions would look like this:
|Tax Year||Cost Basis||Depreciation Deduction||Cumulative Depreciation|
In the first year, you’d take a prorated depreciation deduction since you didn’t own the property for the entire year. In 2020, you’d take the full depreciation amount, calculated as $200,000 divided by 27.5. In 2021, you’d add $40,000 to your cost basis and recalculate your depreciation deduction from that amount, where it would stay until you invested more money in capital improvements or until the cumulative depreciation adds up to the entire cost basis.
When in doubt…
There’s plenty of gray area here. Let’s say you aren’t sure which of your acquisition costs should be included in your cost basis or you aren’t quite sure how to determine the value of your land.
In cases like these, I can’t overstate the importance of seeking the help of a qualified tax professional. Because it’s a potentially large tax deduction (and can be abused), the IRS scrutinizes depreciation more than most tax benefits. It’s better to pay a little bit to be sure you’re doing things right.
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