When it comes to investments, real estate can offer some solid benefits. Property appreciation, tax breaks and in the case of rental property, recurring cash flow can turn your property into a money generating investment. You can take advantage of these benefits whether you use a Property Management company or self-manage your own rentals.
In many ways, the law seems to favor real estate investors and rewards those who make this type of investment with a number of opportunities for different tax breaks.
One tax break that many landlords benefit from is depreciation; which allows you to recover some of the cost of income-producing property through yearly tax deductions. You can do this by depreciating the building, and in some cases, the personal property inside by deducting some of the cost each year on your tax return.
Generally speaking, depreciation results in more money in a landlord’s pocket. Since the single largest expense that most landlords have is the cost of the rental property, being able to depreciate it allows you to claim a significant portion of that expense by spreading it out over the course of a number of years, thereby reducing the amount of tax that you owe.
If you’re currently a landlord or are thinking about buying an investment property, having a basic understanding of the deductions that you may be eligible for can help you to save significantly on your tax bill. In the case of depreciation, it can also help you to prepare for unexpected costs down the road, allowing you to manage your portfolio and structure your deals in a way that will benefit you the most.
With this in mind, let’s take a look at depreciation for rental property, and see how you can use this deduction to reduce your tax bill.
What Is Depreciation?
Depreciation, in a nutshell, is based on the concept that some assets are depreciating in value.
While real estate in most areas is an appreciating asset increasing in value, the truth is that the building itself along with some of the property inside the building, like appliances, are things that’ll wear out over time. As the years go by, property wears out, decays, or becomes otherwise unusable.
Depreciation is an annual tax deduction that landlords can take that reflects this cost.
With depreciation, landlords can depreciate the value of the building, land improvements, such as landscaping, as well as personal property items that are inside the building, but not physically part of it; for example, refrigerators, stoves, and carpet.
One thing that makes depreciation so valuable for landlords is the fact that you get to take it year after year. In the case of most rental properties, the cost of depreciation is spread out over the course of 27.5 years, making it a long-term benefit. Additionally, unlike many deductions, landlords don’t have to pay anything in order to claim depreciation, aside from the cost of the original asset, and owners are entitled to depreciation even if their property goes up in value over time, as is often the case.
Here’s a practical example of how depreciation works:
Example: Denise purchases a rental property with a depreciable value of $100,000. Because of this, she is entitled to a yearly depreciation deduction of $3,636 for the next 27.5 years (excluding the first and last year, when it will be somewhat less). The only thing Denise has to do to get these annual deductions is to keep the property as a rental, file a tax return, and do some simple bookkeeping. She doesn’t need to spend an additional penny on this property.
Depreciation Recapture
Now, there’s a downside to depreciation that most people tend to overlook, that is, depreciation recapture.
Depreciation recapture is a small “Gotcha!” from your friends at the IRS, which requires you to pay 25% tax on any gain realized through depreciation.
So if you were to sell your rental property down the road, you’ll have to pay 25% tax on the total amount of depreciation deductions that you took over the years.
Of course, there are a few alternatives to this tax.
One alternative is using what’s known as a 1031 deferred exchange, or a “like-kind exchange”, which allows you to defer this payment. With an 1031 exchange, when you sell your property you can roll the depreciation into the next property that you purchase. The downside to this option, though, is that you’re simply deferring the tax. You’ll still have to pay recapture taxes when you sell the exchanged property in the future.
Another option is not selling the property at all, but instead keeping it as a rental and then passing it on to your heirs. When they inherit the property, they won’t have to pay your depreciation recapture taxes.
A third option is to sell the property at a loss, but of course, this is a far less popular option.
In most cases, the longer you wait before you sell, the less of an impact the depreciation recapture taxes will have. This is because you’ll have had many years to make use of the additional tax savings that accrued from using depreciation. Additionally, you may not be in the same tax bracket that you would have been in had you made the sale earlier on.
Keep in mind that there are a number of different ways that you can structure your investment properties and use tax deferral strategies to avoid depreciation recapture taxes. It’s a good idea to speak with an accountant to see what your options are and to find out how you can best take advantage of depreciation.
Depreciation Is Not Optional
At this point, you may be thinking, “Ok, I’ll just skip depreciation, and not claim it”.
Unfortunately, depreciation is not optional. You must take a depreciation deduction if you qualify for it.
If you fail to take it, the IRS will still treat you as though you had taken it. This means that if you sell your property, its value for tax purposes will be reduced by the amount of depreciation that you failed to claim. You’ll show a larger profit from the sale that you’ll have to pay taxes on.
If you have unclaimed depreciation, you can deduct the entire amount in one year. To do so, you’ll want to make what is known as an I.R.C. Section 481(a) adjustment and file IRS Form 3115 to request a change in accounting method. Generally, this type of change is granted automatically by the IRS, and you won’t need to file any amended tax returns. You may need to seek out an accountant, though, as it’s a confusing form.
What Can Be Depreciated?
First, there’s depreciation on the rental building itself. This usually accounts for the largest depreciation deduction that you can take.
With this deduction, the rental building itself (the structure) can be depreciated. The land that it’s sitting on, however, cannot. This makes sense when you think about it. While the house may be slowly wearing down with time, land doesn’t wear out or “depreciate” in the same way.
Secondly, personal property that’s a part of your rental business, can also be depreciated. This includes things like appliances or furniture in the house, as well as office or construction equipment, cars, and other vehicles that you own, and use for the rental properties.
Of course, only property that you own is able to be depreciated. You can’t depreciate property that you lease for your rental activity such as office space. Additionally, you aren’t able to depreciate property that’s solely for personal use. So no depreciation for your personal residence, and should you convert a rental property to a personal residence, you must stop taking the depreciation for the property. If a property serves as both a rental and for personal use, you may depreciate only part of its value; the percentage of the property used for rental purposes.
Note: Thanks to the new GOP tax bill; the Tax Cuts and Jobs Act, depreciation for assets that have “useful lives of less than 20 years” has increased from 50% to 100%. This means that if you buy appliances or new carpet, or make land improvements, you can write off the entire cost of these expenses in the year that they occurred.
Finally, the amount of your depreciation is based on the cost of the property itself. The amount that you borrowed to purchase –i.e. the interest rate on the loan is irrelevant. You can, however, deduct interest on the mortgage, or for HELOCs that are used for the property.
How Does Depreciation Work?
Practically speaking, how do you go about claiming it on your tax return?
First, you must determine what’s known as your property basis, that is, how much the property’s worth for tax purposes.
Usually, your basis is the cost of the property, and any expenses of the sale such as real estate transfer taxes.
Land cannot be depreciated, so it must be deducted from the cost of the property.
Next, you must determine the depreciation period, or “recovery period” of the property or aspects in question, that is –how long the IRS says you must depreciate it for.
Real property placed into service after 1986 is depreciated under what’s known as the Modified Accelerated Cost Recovery System (MACRS). Under this system, the depreciation period for residential real property placed in service after 1986 is 27.5 years. Prior to 1987, different depreciation methods with different depreciation periods were in effect.
The periods are the same whether the property being depreciated is old or new. When you buy property, you start a new depreciation period beginning with year one, even if the prior owner previously depreciated the property as well. This makes no difference to you, though, your depreciation period starts when you purchase the property.
You then deduct a certain percentage of its basis each year during its recovery period.
Next, you’ll want to calculate your deduction amount. Your depreciation deduction is a set percentage of the basis of your property each year.
This percentage varies, depending on the depreciation method you use. All real property must be depreciated using the straight-line method. Under this method, you deduct an equal amount each year over the depreciation period, generally 27.5 years.
At the end of the day, depreciation can be a useful and often-necessary deduction that landlords can take. Just make sure you work with a good accountant, who can fill you in on depreciation, as well as depreciation recapture if you’re planning to sell the property down the road. This will allow you to structure your purchases in a way that will benefit you the most and will help to keep you from being hit with any unexpected taxes in the future.
To learn more about depreciation, be sure to check out the IRS Publication 946 (2017), How To Depreciate Property.
Here are some additional resources about Real Estate Tax Deductions and 1031 Exchanges:
- 1031 Exchange In Real Estate-Paul Sian
- Home Buying Tax Deductions Checklist-Bill Gassett
- Home Buyer Tax Deductions-Anita Clark
Please Note: While this article contains information that we’ve learned from classes and from working with our clients over the years, please keep in mind that we are not tax professionals. This information is intended to inform and to guide only, and it is not meant to serve in place of tax advice from a licensed tax professional. These principles should only be applied in conjunction with a CPA. To learn more about depreciation as it applies to your own financial situation, please consult a tax professional.
Security deposits, though, are not a simple cut and dry issue. Each state has different laws and requirements pertaining to the collection, use of, and sometimes even storage of security deposits, and landlords should take care to ensure that they’re operating in a way that’s in compliance with both state and municipal law. Additionally, security deposits are often a hotly contended issue –tenants usually assume they will be getting all of their deposit back, while landlords will usually attempt to keep the deposit and use it to fix up the rental. Property managers, unfortunately, often find themselves stuck in the middle –trying to ensure that the deposit is applied correctly, while at the same time helping to manage the expectations of both the landlord and the tenant. Little wonder that 
In addition to damages, a security deposit can also be applied toward cleaning the rental, especially if it was excessively dirty. Trash or belongings left behind, grime or dirt in the kitchens and bathroom, and a general state of uncleanliness can usually all be considered excessively dirty.