It’s all true that investing in real estate goes along with huge tax advantages. But if you know how to use depreciation rules on your real estate assets, it can drastically lessen an investor’s taxable income. In a lot of cases, it can eliminate income taxes completely.
If you’re interested in how rental property depreciation works and why it’s a benefit to investors, then this article is for you.
What is depreciation?
For you to easily understand what depreciation is and how it works, you must understand first that there are two ways businesses can reduce the cost of assets they buy. The price of smaller and temporary items like repairs or the amount of money spent to buy office supplies is usually deducted all at once. Meanwhile, the value of assets have a useful life of one year or more and it can be lessened over a longer period of time. This is called depreciation.
How to depreciate an asset?
For an asset to be depreciated, it must have a quantifiable useful life. For instance, a business purchases a piece of machinery for $10,000. You can reasonably expect that this item can last for 10 years. This means that the business can reduce $1,000 of this cost every year for 10 years.
Depreciation provides the opportunity for capital expenditures to minimize the business’s taxable income for a number of years. Specifically, that can be beneficial to rental real estate businesses.
What is rental property depreciation?
Real estate investors use rental property depreciation as a method to deduct the costs that come along with buying and enhancing an investment property. Depreciation of rental property occurs over the course of the property’s useful life as identified by the IRS’ depreciation method. This is essential for investors since rental property depreciation can help maximize tax savings.
How does rental property depreciation work?
This type of depreciation is a capital expense that helps recuperate the costs you spend to obtain and improve your rental property. Depreciation expense is normally the biggest tax deduction available to real estate investors and can help them improve their cash flow by lessening their tax liabilities. This means that you can reduce your taxable income every year without conflictingly impacting your cash flow.
What is the best depreciation method for a rental property?
The most ideal method is the MACRS. There are two kinds of MACRS: ADS and GDS. The most common method is the GDS method that expands the depreciation of rental property over its useful life, which the IRS recognizes to be 27.5 years for a residential property.
Now, let’s discuss the formula for MACRS which is the price basis of the asset multiplied by the depreciation rate. The cost basis is similar to the purchase price of the property. To find which depreciation rate you need to use, you can refer to one of the three tables the IRS gives in Publication 946.
Here is the MACRS formula using GDS: Cost basis of the asset x Depreciation rate
For you to be able to understand how MACRS is used, here’s an example. The IRS indicates that any residential rental property utilized for service after 1986 is depreciated using the productive life of the property. However, we still recommend that you consult with a tax professional to calculate MACRS even if it’s simple to do because depreciation rates that are utilized differ depending on the kind of asset being depreciated.
MACRS is particularly used in real estate itself, but when it comes to other improvements, the straight-line depreciation method is typically the one you need to use. This means that these things can be deducted and depreciated over time including a new roof, new windows, plumbing systems, doors, etc.
Is it possible to claim depreciation on my rental property for previous years?
Yes, you can and you should claim depreciation on your rental property. You should be able to do that by claiming a catch-up depreciation on this year’s return. Catch-up depreciation is the modification or adjustment to proper improper depreciation. This happens when you haven’t claimed depreciation in earlier years on a depreciable asset, or you have claimed less or more than the permitted depreciation on a depreciable asset.
This means that a catch-up depreciation is a ‘change’ in the method of accounting used before.
What is a rental property depreciation schedule?
It’s a schedule that helps you know the costs of your assets, calculate your capital expenses, and calculate depreciation expenses. A rental property depreciation schedule shows you the type of depreciation you can acquire and deduct every year. It displays the breakdown of the value of the land and the value of the building because you are only able to depreciate the building value. This depends on the useful lifespan allowed by the IRS for the property type.
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