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What Is Depreciation?

If you buy an investment property (or improve one you own) you can use this tax tactic to recoup some of your investment.

[Updated: Feb 04, 2021] Oct 22, 2019 by Daniel B. Kline
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Certain assets become less valuable over time. A car, for example, loses value from the minute it’s driven off the lot until it stops functioning.

Value, of course, changes based on use. A car that has been steadily maintained and driven 10,000 miles a year has more practical value than one that has been poorly maintained and driven 100,000 miles a year.

Depreciation is a tax tactic that lets you deduct a percentage of the lost value on your taxes each year. It’s a formula that can (and should) be applied by anyone who invests in rental property.

When it comes to using depreciation as a tax deduction for rental property, however, the actual condition of the property isn't relevant. The IRS lets owners depreciate rental property over its expected life, which the IRS says is 27.5 years. To do that, you have to understand how depreciation works and what can be depreciated.

When it comes to using depreciation as a tax deduction for rental property, however, the actual condition of the property isn't relevant. The IRS lets owners depreciate rental property over its expected life, which the IRS says is 27.5 years. To do that, you have to understand how depreciation works and what can be depreciated.

The basics of depreciation

Depreciation only applies to buildings -- not the land they sit on. Before you can do anything, you need to separate those two values. Usually, this information is on your tax assessment.

You can also depreciate the cost of significant improvements, like putting on a new roof or redoing the kitchen. The IRS provides a useful list of examples.

Routine maintenance isn't included. So adding central air can be depreciated, but having your air conditioning unit serviced cannot.

Your depreciation period doesn't begin when you buy the property. Instead, it starts when the property gets put into the rental market. That's the day it becomes available for rental, not when you first rent it out. The IRS does, however, have a few requirements you need to meet to depreciate your property:

  • You must own the property.
  • You have to use the property to produce income (almost certainly by renting it).
  • The property has to have a determinable useful life of more than one year (there’s no real IRS rule on this, but it’s clear that you can’t depreciate a roof tarp or cardboard put over a broken window).

That’s a low bar to clear, but there’s a second hurdle that’s a little higher. The IRS limits how much time you can spend in your property when it’s not being rented out and still call it a rental for depreciation purposes. You rental is considered a residence -- which can’t be depreciated -- if you use it for personal use

  1. more than 14 days in a year, or
  2. more than 10% of the total days you rent it to others at a fair rental price

You may use more than one dwelling unit as a residence during the year. For example, if you live in your main home for 11 months, your home is a dwelling unit used as a residence. If you live in your vacation home for the other 30 days of the year, your vacation home is also a dwelling unit used as a residence unless you rent your vacation home to others at a fair rental value for 300 or more days during the year in this example.

For rent sign

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How does depreciation work?

Depreciation isn’t a fixed number. In year one, you'll be able to depreciate 3.636% of the original cost basis of the property and any qualified improvements. That number may change in future years as you make new improvements.

Let's take a look at an example. You buy a house for $100,000. Five years later, you pay $8,000 for a new roof.

Here's what your depreciation would look like through the first five years:

  • Year 1: $3,636.36 (this is 3.636% of $100,000).
  • Year 2: $3,636.36.
  • Year 3: $3,636.36.
  • Year 4: $3,636.36.
  • Year 5: $3,927.26 (the depreciation deduction on the house plus 3.636% of the $8,000 roof).

You can use this new number, $3,927.26, until you accrue another depreciable expense or until the original 27.5 years of the house's depreciation schedule has run out. At this point, the new roof will still have four years go to, and you can deduct $290.90 from your taxes each year until it runs out.

To make this even more complicated, not all improvements have the same depreciation timetable. The IRS has a table that shows the period of depreciation for various expenses.

A new fence, for example, has a 15-year depreciation period, while office furniture depreciates over seven years. New roofs and a kitchen overhaul, however, have the full 27.5 years. Of course, a new stove in the kitchen wouldn't. You can see why record keeping is important and why you may need a good accountant.

It’s very important to keep very good records if you plan to depreciate hard items or improvements in addition to the value of the property. It’s best to have receipts and contracts along with before-and-after pictures. If the IRS has questions, it’s vital to have full documentation.

The process for depreciating a rental property placed into service after 1986 is called the Modified Accelerated Cost Recovery System (MACRS). Within that, there are two systems for depreciating your property:

  1. The General Depreciation System (GDS) is used in most cases.
  2. The Alternative Depreciation System (ADS) is generally only used if you’re legally required to. If your property is used for business 50% of the time or less, if it has a tax-exempt use, if it’s financed by tax-exempt bonds, or if it’s used primarily in farming, you may use the ADS.

A GDS property is depreciated over the 27.5-year period covered above. An ADS property is depreciated over 30 years if it was put into service in 2018 or later or 40 years if it was placed into use before that.

In most cases, you'll use GDS and the formulas above apply.

It’s also worth noting that you don’t stop taking depreciation when a property has been temporarily vacant. If, for example, you take the property off the market while you make repairs after a tenant leaves, you can still take depreciation.

The depreciation period ends when you either take the property out of use (by selling it or converting it to a personal-use property) or you've depreciated the full value. For accounting purposes, you have to take any depreciation you could have taken. Even if you didn't claim it, the IRS still knows about the depreciable value. And you can't retroactively claim depreciation.

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Why does depreciation matter?

When you own a rental property, some expenses are tax write-offs. You can, for example, use actual expenses (like the cost of routine maintenance, property taxes, and travel costs related to the property) as tax deductions. These costs are deducted in the same year and can only be used to offset rental income. If you have more costs than you bring in, you won’t get an added benefit, but you can have zero taxable income on the property.

Depreciation, however, reduces your overall tax liability. It’s a tax deduction that lowers your income, so if you're in the 24% tax bracket and deduct $5,000 in depreciation on your rental property, you'll save $1,200 on your tax bill.

In theory, it’s possible that depreciation could also lower your tax bracket by offsetting your rental income. That can result in significant savings, though it likely requires a lot of planning.

There's a wrinkle when it comes to depreciation, however. If you sell your property for more than its depreciated value, you owe taxes on that gain. That's called “depreciation recapture.” The good news is that the maximum tax rate for depreciation recapture is 25%. If you're in a higher bracket, you'll get a little bit of a break.

You can also avoid taxes when you sell a rental property by using a 1031 exchange, also called a “like-kind” exchange. That means you sell the property and use the proceeds to buy a similar rental property.

Depreciation is a vital tool for anyone who invests in rental property. It can, in some cases, be the difference between losing money and making money -- especially in a year where you have significant expenses. It’s not a simple concept, so it may make sense to use an accountant familiar with rental property. But, despite its complexities, depreciation is a major part of the appeal of buying and renting property.

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