You’ve likely heard of depreciation on equipment and other items in business, but did you know depreciation in real estate is possible? In fact, it’s one of the most important deductions you can take as a real estate investor, as it reduces your taxable income each year you have a property in service and available for rent.
So, what is depreciation in real estate, and how does it work?
What It Means When Real Estate Depreciates
Real estate depreciates over time, meaning it slowly loses its value as it ages compared to its value when you purchased it. This is through normal wear and tear and intended use.
The IRS helps real estate investors offset the cost of purchasing investment properties by offering annual depreciation. If you invest in residential real estate, the IRS factors the depreciation over 27.5 years, the average useful life.
The deprecation deduction can help offset income earned from owning a rental property, such as rental income or any other income from other provided amenities.
Depreciation isn’t cash you put out or earn; instead, it is an accounting term that lowers your income on paper and reduces your tax liability.
How Is Real Estate Depreciated?
The IRS uses the Modified Accelerated Cost Recovery System to depreciate real estate. Any investment property you purchase after 1987 is subject to this system and can be depreciated over 27.5 years, or a property’s typical useful life.
What Is the Most Common Depreciation Method?
There are two types of depreciation: straight line and accelerated. However, straight-line depreciation is the most commonly used method. It’s the simplest method, as it provides a fixed amount of depreciation annually based on the property’s cost basis.
Accelerated depreciation allows property owners to deduct a larger percentage of the cost basis in the first year or first couple of years but leaves nothing for depreciation for the remainder of its useful life.
To calculate real estate depreciation, you must know the following:
- Property’s cost basis (purchase price, plus any other acquisition costs)
- Expected useful life (IRS uses 27.5 years)
When calculating the property’s cost basis, determine its purchase price plus any capital expenditures, including:
- Legal fees
- Title insurance
- Recording fees
From the cost basis, you must subtract the land’s value, as land doesn’t depreciate.
For example, you purchased a property for $275,000. The appraiser determined the lot was worth $20,000, and your capital expenditures to purchase the property are $4,000. Your cost basis for the property is as follows:
- $275,000 purchase price
- Subtract $20,000 land value
- Add $4,000 capital expenditures
Your cost basis is $259,000. If you put the property in service by Jan. 1, you’d divide $259,000 by 27.5 years for an annual depreciation of $9,418.18.
Tax Benefits of Depreciation on Real Estate
Depreciation greatly affects your tax liability for the year because it is an expense on Schedule E that directly lowers your income.
Depreciation lowers your income and affects your net gain or loss on the property. You combine depreciation with other expenses to lower your overall tax liability.
What can’t you depreciate?
In addition to land, there are a few other costs you cannot use in your acquisition costs to determine a property’s cost basis.
These include certain settlement fees, such as:
- Origination points
- Mortgage insurance premiums
- Fire insurance premiums
- Appraisal fees
You also cannot depreciate property you bought and sold in the same year or equipment used to make capital improvements to the property.
When Can I Start Depreciating My Property?
Real estate depreciation begins when the property is placed in service or made available for service.
For example, say you buy a rental property on Jan. 5, but it takes three months to renovate it, making it available for rent on May 1. You can begin taking depreciation on May 1, even if it isn’t rented out yet.
How Much Is Depreciation?
The amount of depreciation you can take varies based on the property’s cost basis and when you put the property into service. You cannot deduct depreciation for times you sit on the property idle, not making it available for rent.
For each full year the property is in service, you can deduct 3.636% of your cost basis. If you put the property in service midyear or anytime after Jan. 1, you’ll get a prorated amount of depreciation for that year. The prorated amount depends on when you put it into service:
|Month Put in Service||Depreciation Percentage (First Year)|
This means you can depreciate $3,636 each year for every $100,000 in a property’s cost basis for each full year the property is in service.
What Is Depreciation Recapture?
Property depreciation is a benefit while you own investment properties. However, when you sell the property for a profit, the IRS wants their portion of the earnings in the form of depreciation recapture.
Depreciation recapture means you pay taxes on any depreciation you’ve taken while you own the property at a rate of 25%.
Any capital gains on the property exceeding the depreciation recapture are taxed at your capital gains rate of 0%, 15%, or 20%, depending on your tax bracket.
Strategies to Manage Depreciation as a Real Estate Investor
To manage your depreciation and make the most of the deduction, consider the following:
- Keep up the property’s useful life with regular maintenance.
- Make improvements and upgrades to increase the property’s cost basis.
- Reinvest profits, such as with a 1031 exchange, to avoid depreciation recapture.
The answer to what depreciation in real estate is important, as it’s one of the main deductions you can take as a real estate investor. You can continually increase your depreciation deduction by improving properties and keeping them in business.
You can also avoid depreciation recapture by taking advantage of 1031 like-kind exchanges until you’re ready to stop investing in real estate. While you invest, though, depreciation is one of the most important deductions you can take.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.