You may have heard that investing in real estate comes with big tax advantages. It’s true. Specifically, the ability to use depreciation rules on real estate assets can dramatically reduce an investor’s taxable income. In many cases it can even eliminate income taxes entirely.
Here’s a rundown of rental property depreciation, how it works, and why it’s such a benefit to investors. We’ll also look at the ways depreciation can affect you after you sell a property and how to avoid paying the IRS for the profits from sold properties.
What is depreciation?
In simple terms, there are two ways businesses can deduct the cost of assets they buy. The cost of smaller and non-durable items, such as repairs or money spent on office supplies, is generally deducted all at once. On the other hand, the cost of assets that have a useful life of one year or more can be deducted over a longer period of time. This is known as depreciation.
To depreciate an asset, it needs to have a quantifiable useful life. Let’s say a business buys a piece of machinery for $10,000. This item can be reasonably expected to last for 10 years. So the business can deduct $1,000 of this cost each year for 10 years.
Some assets (including rental properties) have IRS-determined useful life spans that we’ll get into later. Depreciation allows capital expenditures to lower the business’ taxable income for a number of years. That’s particularly helpful to rental real estate businesses.
How rental property depreciation works
If you buy a property with the intention of renting it, you can depreciate the cost of acquiring the property over a period of time.
There’s obviously no one-size-fits-all useful life when it comes to rental properties. Some cheaply built homes are worn out after a decade or so. Some historic homes have been around for 100 years or more and are still in perfectly rentable shape.
So the IRS provides guidelines when it comes to the depreciation of real estate. Most real estate investors buy residential rental properties. The IRS says you can treat these as having a useful life of 27.5 years. In other words, you can divide your cost basis in the property by 27.5 to determine your annual depreciation "expense." If you own a commercial property, the depreciation period is 39 years.
Another important concept is that only the value of the building itself can be depreciated. Not the land that it’s built on. Buildings have a useful lifespan, but land does not. Land will never be "used up."
There are a few acceptable ways to determine the value of a building versus the land it’s on. You can have the property appraised by a qualified professional, for example. A tax assessment is another way to separate the value of land.
You can continue to depreciate a rental property over time until you sell the property or you’ve depreciated your entire cost basis.
What's your cost basis in a rental property?
You might think your cost basis is the amount of money you paid for a property. But it’s not always that simple.
The cost basis for rental real estate is your acquisition cost (including any mortgage debt you obtained) minus the value of the land it's built on. If you paid $200,000 for a duplex and the land is appraised for $50,000, your basic cost basis is $150,000.
However, there are some other costs that can be included in your cost basis. These include the following (but there are other applicable costs, as well):
- Any debts of the seller that you assume. For example, if you agree to assume a $5,000 loan that the seller owes, that would be added to your cost basis.
- Legal costs you incurred while acquiring a property.
- Recording fees.
- Property survey costs.
- Transfer taxes.
- Title insurance costs.
Your cost basis can also be adjusted over time -- this is your "adjusted basis." This includes the cost of improvements or additions you make to the property. It also includes expenses related to casualty damage or the cost of running utilities to the property.
Imagine that your original cost basis in a property is $200,000. You then spend $30,000 putting a new roof on it and $25,000 on renovations. Your adjusted cost basis for depreciation purposes is $255,000.
Can your rental property be depreciated?
In order to depreciate rental property, you have to meet the following criteria:
- You must own the property. You can’t rent a property, sublet it to someone else, and then claim a depreciation deduction.
- You must use the property to generate income. For real estate purposes, this typically means you rent it to tenants.
- You must be able to determine a useful life for the property. As we discussed in the previous section, residential real estate has an IRS-determined useful life of 27.5 years, while commercial real estate has a useful life of 39 years. This requirement is why land can’t be depreciated, as land is never "used up."
- The property must have a useful life of more than one year. This isn’t an issue with rental real estate, but for other capital expenditures, it gives a good guideline as far as what property can be depreciated and what should be expensed immediately. For example, a new range you install in a rental property can be reasonably expected to last for more than a year. A "for rent" sign that you buy and place in front of the property cannot, and should be treated as an immediately deductible expense.
Also, to depreciate a rental property, you should plan to hold it for more than a year. If you plan to buy a house, fix it up, and sell it a few months later (a "fix-and-flip"), you generally can’t depreciate the property during your holding period.
If you're unsure whether you should claim a depreciation expense on a property you held for a short time, consult a qualified tax professional.
How to calculate depreciation
If you own a rental property for an entire calendar year, calculating depreciation is straightforward. For residential properties, take your cost basis (or adjusted cost basis, if applicable) and divide it by 27.5.
Put another way, for each full year you own a rental property, you can depreciate 3.636% of your cost basis each year. If your cost basis in a rental property is $200,000, your annual depreciation expense is $7,273.
For a commercial property, divide your cost basis by 39. This gives you a 2.564% depreciation expense for each full year you own the property.
It's more complicated when you own the property for only part of a calendar year. This generally occurs in the years when you buy and sell a property. In these cases, you can prorate the depreciation based on how many months of the year you used the property to generate rental income.
The IRS provides the following table for use during the year you acquire a property:
|Month the Property Was Put Into Service||Cost Basis Percentage You Can Depreciate|
In the year you sell a rental property, this works the opposite way. You can take the depreciation deduction for the months the property was in service (prior to the sale).
Another case where you might take a partial depreciation deduction is in the year when your deduction has been used up. Your total depreciation over time cannot exceed your (adjusted) cost basis.
Here's an example. If your adjusted cost basis in a property is $250,000, and you’ve already depreciated $249,000 before the current calendar year, the most you’re allowed to depreciate this year is $1,000. Regardless of your calculated depreciation deduction.
An example of rental property depreciation
Let's look at an example of how rental property depreciation works over time.
Say you acquire a rental property for $250,000 with the intention of holding it for 30 years. The land value is appraised at $50,000 for a cost basis of $200,000. We’ll assume that you don’t make any major improvements or renovations right away or during your 30-year holding period. But if you did, they would be added to your $200,000 cost basis.
We’ll also say that you purchase the property on Sept. 1, 2019 and put it into service in the same month. According to the IRS table in the previous section, you’ll deduct 1.061% of your cost basis in 2019 and 3.636% of the cost basis in each year thereafter until your entire cost basis has been depreciated.
Why depreciation is such a big tax advantage for real estate investors
Depreciation is one of the biggest tax advantages for rental property owners because it provides an annual tax deduction that isn’t really an expense. Let’s say you have a rental property that produces $6,000 in annual income after expenses. A $4,000 depreciation expense will reduce your property’s taxable income to just $2,000.
For this reason, rental income generally has a lower effective tax rate than virtually any other type of income. In fact, it isn’t uncommon for rental properties to show a loss for tax purposes, even though they're quite profitable.
Other deductible expenses for real estate investors
Depreciation is a big and valuable tax break for rental property owners, but it isn’t the only way to reduce taxable rental income. Here are some more expenses that can be deducted:
- Property management.
- Maintenance (this refers to maintenance items like fixing toilets and servicing HVAC units, as opposed to any property improvements or renovations, which add to the investor’s cost basis).
- Property taxes.
- Utilities paid by you.
- Advertising costs when seeking a tenant.
- Expenses related to obtaining and retaining tenants.
- Travel expenses to and from your rental properties. However the expenses must be reasonable. For example, you can’t buy a rental property in Florida, spend a week there on vacation, and write off the entire trip.
- Interest paid on a mortgage on the property.
- Points paid to obtain your mortgage.
- Insurance on the property.
- Cleaning expenses.
- Legal fees related to operating the property.
How can depreciation help you keep more money in your pocket?
Depreciation, along with rental income and property-related expenses, is reported on IRS Schedule E. To illustrate how valuable depreciation can be to a property owner, consider an example of an investor who acquires a rental property for $200,000. Say that property brings in $1,800 in monthly rental income. We’ll assume this investor is in the 24% tax bracket.
This investor had the following income and expenses last year:
|Item||Annual Income (Cost)|
Based on the property’s income and expenses, this investor would have $8,440 in rental income. Based on the 24% tax bracket, this translates to income tax of about $2,026.
However, based on the depreciation rules we’ve discussed, this investor would also be entitled to a $7,272 depreciation deduction. This brings the property’s income all the way down to $1,168. Even though this investor made a profit of $8,440 this year, depreciation lowers taxable income to a small fraction of this amount.
Now the 24% tax rate only translates to $280 in tax liability -- a savings of $1,746. That translates to an effective tax rate of just over 3% on the property’s actual income.
Parts of your rental property business may depreciate faster
There are some rental property expenses that you can depreciate faster than the standard 27.5-year life span for residential real estate. For example, the IRS considers appliances to have a lifespan of five years. If you install a new refrigerator in a rental property, you could choose to depreciate it over five years instead of considering it an improvement and adding it to your cost basis.
In many cases, this isn’t worth it. Depreciating individual assets can get complicated fast and greatly increases tax preparation expenses. For example, if you renovate all three kitchens in a triplex, it's easier to add the cost of the renovations to your cost basis as opposed to depreciating each appliance according to their individual life spans.
But there are some situations where depreciating individual assets comes in handy. For example, if your rental property operation gets large enough that you have an office and dedicated office machinery and furniture, you’ll likely depreciate these as individual assets. That said, individual rental properties are often best considered with a single cost basis, as opposed to an asset-by-asset analysis.
Here are some IRS guidelines for the lifespans of certain assets that could be relevant to rental property owners:
- 5-year property: Computers, office machinery, automobiles, appliances, carpeting, and furniture. If you're renting a furnished apartment and you purchase a new sofa, you could use a five-year depreciation schedule for it.
- 7-year property: Office furniture and equipment.
- 15-year property: Roads and fences.
How depreciation affects selling
Depreciation can be one of your best friends when you own a property. On the other hand, when you sell a rental property, depreciation can be your worst enemy.
Here’s the quick version. As you take depreciation deductions each year on your tax return, your cost basis in the property declines for capital gains purposes.
In other words, if your cost basis in a property is $200,000 and you’ve taken a total of $25,000 in depreciation since you’ve owned it, the IRS calculates capital gains based on an investment of $175,000. This means that if you sell the property for $300,000 (after expenses), the IRS calculates capital gains tax based on a profit of $125,000 instead of $100,000. This concept is called depreciation recapture.
One way to get out of paying capital gains tax on the sale of a rental property is by completing what’s known as a 1031 exchange. This means that you can avoid paying capital gains tax by using the proceeds from the sale to invest in a comparable property.
We won’t get too deep into the details of how a 1031 exchange works. If you’re interested in learning more, check out our 1031 exchange page.
The basic idea is that you need to purchase new real estate shortly after the sale and you must use essentially all of the sale proceeds to purchase the new property. In other words, if that $300,000 sale paid off a $150,000 mortgage and gave you $150,000 in cash, your new property should have roughly the same capital structure.
What if you didn’t claim depreciation on a property you own?
The depreciation deduction is a foreign concept to many rookie real estate investors. It’s not uncommon for first-time property owners to overlook it, especially if they file their own tax returns.
If you’re a rental property owner and learning about depreciation for the first time, you might be kicking yourself for not claiming the expense on your previous tax returns. But there's good news: You can amend your recent tax returns to claim your depreciation benefit retroactively. You can file an amended tax return by completing a Form 1040X as well as any schedules or other forms you’re modifying. As a rental property owner, this would be Schedule E.
Depreciation can save you a lot of money on your taxes. It's a complicated process, but figuring it out for your rental properties is worth the time it takes.