In terms of buying and improving rental properties, depreciation is the process used to deduct any associated costs. Rather than take one large deduction in the year the property was purchased or improved, rental property owners should— as the IRS specifies— spread out those kinds of deductions over the useful life of the property. So basically, instead of a large one-time deduction, owners would be deducting a portion of their purchase and improvement costs (not operating or maintenance costs) each year for several years. This can substantially affect the amount of your taxable rental income that you place on your tax return, making depreciation worth the time it takes to calculate.
The owner of the property can begin taking depreciation deductions as soon as the rental property is placed in service, or another way to say it: when it’s ready to be rented out. That is some positive news for property owners who have to face a vacancy just after purchase or during renovations. The number of years you’d spread the depreciation cost depends on two things. First, how long you own and use the property as a rental, and second, which depreciation method you use.
There are different depreciation methods that give different amounts. Any one of them can be used to determine the amount you can deduct each year. But the most common one for residential rental properties is the Modified Accelerated Cost Recovery System (MACRS). Generally, MACRS is used for any residential rental property placed in service after 1986. Using this method, the cost to buy and improve a rental property is spread out over 27.5 years, which is what the IRS considers to be the “useful life” of a rental house.
To calculate how much depreciation you can deduct each year, you’ll need to know your basis in the property or the amount you paid for it. You may also be able to include some of your settlement fees, legal fees, title insurance, and other costs paid at the settlement. What makes this number difficult to get is that you’ll need to separate the cost of the land from the building since only the rental house itself – and not the land it is built on – can be depreciated. In most cases, you can use property tax values to find out what portion of the purchase price should be allocated for the house, or your accountant might elect to use a standard percentage.
When you’ve computed the amount just for the rental house, you’ll need to do one more thing, and that’s to figure out your adjusted basis. A basis in a rental property can be modified to account for things like major improvements or additions, money spent restoring extensive damage, or the cost of connecting the property to local utility service providers. The basis may also decrease in the event of insurance payments you received to cover theft or damage and any casualty losses you took a deduction for already that were not covered by your insurance. From the adjusted basis, you can now calculate the amount of deprecation you can deduct on your income tax return.
Depreciation of a rental property is a valuable tool for investors looking to reduce their annual tax obligation. However, it’s a bit more complicated since rental property tax laws can be complex and change quite a bit every few years. This is why it’s best to work with a qualified tax accountant to ensure that depreciation is being calculated and applied correctly.
When you work with Real Property Management DC Metro, we can have accounting professionals work with you and help you through your depreciation questions and more. Working together with our experts can help property owners make sure that there are no unpleasant surprises when tax time draws near. If you want to know more about our Georgetown property management services, don’t hesitate to contact us online or call us at 202-269-0303.