The Landlord's Guide to Rental Property Depreciation

October 26, 2022
● Written by
Julia

As a landlord, you know the importance of maintaining your rental property and keeping it in good condition. But did you know that regular upkeep and improvements can also help you save on taxes through rental property depreciation? That's why many landlords make it a point to understand and take advantage of depreciation.

What is Rental Property Depreciation?

Depreciation is an income tax deduction that allows a business or property owner to "write off" the cost of an asset over its useful life. Assets lose value over time due to wear and tear and the tax code lets you fully reduce the value of the property.

The building itself and any furnishings or appliances included in the rental can be depreciated. The land itself, however, cannot be depreciated because it typically does not lose value over time.

If you want to claim depreciation for your rental property, there are a few requirements that must be met:

  • You must use the property for business or income-producing purposes
  • The property has a determinable useful life
  • The useful life must be at least one year
  • You have to own the property

According to the IRS, you can use Form 4562 to report depreciation.

Defining useful life

So, how exactly do you determine the useful life of a rental property or its assets? The IRS sets guidelines around "useful lives" but leaves the depreciation methodology up to the property owner. The useful life is sometimes referred to as the "recovery period" and can apply to any property that depreciates.

Recovery is the time it takes for a property or asset to be fully written off through depreciation. The IRS considers a 27.5-year useful life as the standard for residential buildings. The useful life of a commercial building is typically 39 years.

How do I use the Depreciation tax deduction?

Once the useful life of your rental property and its assets has been determined, you can begin claiming a tax deduction for depreciation. The IRS allows for two methods of calculating depreciation: The General Depreciation System (GDS) and the Alternative Depreciation System (ADS).

Method 1: General Depreciation System (GDS)

Most landlords will use the GDS method for depreciation calculations. In this system, the landlord can often depreciate a larger percentage of the property in the early years.

One key element of GDS is bonus depreciation, which allows for an additional depreciation deduction in the first year a property is placed in service. The current bonus depreciation rate is 100%, meaning you can deduct the full cost of certain eligible assets in the first year.

Method 2: Alternative Depreciation System (ADS)

The ADS method, on the other hand, is only used in specific circumstances. This includes buildings that are:

  • primarily used for farming
  • financed largely by tax-exempt bonds
  • used for qualified business less than 50% of the time
  • used for tax-exempted purposes (eg. church)

Under ADS, you can only take depreciation deductions on a straight-line basis. This means the property is depreciated in equal deductions each year over the useful life. Bonus depreciation cannot be used under ADS.

In 2017, the Tax Cuts and Jobs Act made some changes to ADS, extending the recovery period for residential real property from 30 years to 39 years.

How to calculate depreciation on a rental property

Calculating depreciation on a rental property doesn't have to be complicated, especially under the Accelerated Cost Recovery System (ACRS) method, which assigns a Recovery Period to each class of property.

Determine the cost basis

The first step is to determine the cost basis of your rental property. This includes the purchase price, as well as any improvements or renovations made to the property that increase its value. Closing costs, like title fees and legal expenses, can also be added to the cost basis.

For example, if you purchased a rental property for $200,000 and spent an additional $20,000 on upgrades, your cost basis would be $220,000.

Calculate the depreciation cost

Once you have the cost basis, you can determine the annual depreciation cost by dividing the cost basis by the Recovery Period for that type of property. Using our example above, if the Recovery Period for residential rental properties is 27.5 years (per IRS guidelines), then the annual depreciation cost would be $8,000 ($220,000 divided by 27.5).

What are the Pros and Cons of taking the Depreciation deduction?

It's important to note that depreciation isn't advisable in all cases. The Nophin team lists a few pros and cons for taking the Depreciation deduction.

Pros

The main benefit of taking the depreciation deduction is that it can lower your annual taxable income. This can result in a tax deduction for landlords and potentially increase your cash on cash returns.

Additionally, being able to deduct a larger percentage of the property in early years (via GDS) can help offset the initial spending and capital outlays associated with acquiring a new property.

Finally, depreciation can offset income from other sources. For example, if your rental property is generating a profit but you have a high salary from your day job, taking the depreciation deduction can lower your overall tax liability.

Cons

One potential downside is depreciation recapture. When you eventually sell the property, a portion of your profit may be subject to taxes.

Additionally, the extra paperwork and documentation may not be worth it if the property is only meant to be held for a short time period.

Furthermore, depreciation is a non-cash expense. While it can lower your taxable income for the year, it might not result in any real money put back into your pockets.

Conclusion

Overall, the decision to take the depreciation deduction on a rental property should be carefully considered. As always, consulting a tax professional is a good idea as it can help you make the best decision for your situation.

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Please note: Nothing above should be construed as legal, investment, tax, nor financial advice. This content is for informational purposes only. Consult a lawyer and/or an accountant if the above is right for your personal situation.

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