Owning a rental property and using depreciation can be an effective tax shelter. You can recover the cost of income producing rental property through rental property depreciation; that is deducting some of the cost on your tax return each year.
The IRS acts as if residential real property is losing value, or “depreciating”. Of course, the general rule is that the property will increase in value, or “appreciate” over time. Depreciation is an accounting loss – it only shows up on paper.
Be sure to Depreciate your Rental Property because the IRS assumes that you take it! If you don’t take the Depreciation, you will have to pay taxes on the property when you sell it through Depreciation Recapture!
Residential property subject to the 27.5 year recover period is defined as a rental building or structure for which 80% or more of the gross rental income from dwelling units. If you occupy any part of the building, the gross rental income includes the fair rental value of the part you occupy.
Factors to Determine Rental Property Depreciation
Three basic factors determine how much deprecation you may deduct for your rental property:
- 1. Basis in the property
- 2. Recovery period for the property
- 3. Depreciation method used
You can deduct depreciation only on the part of your property used for rental purposes. If you rent a room in your house you can only deduct a percentage of the depreciation available. Visit our renting a room section to learn more. If you rent a rental property, you may deduct the entire amount of depreciation available to you. Depreciation reduces your basis for figuring gain or loss on a later sale or exchange.
Rental Property Depreciation Requirements
You can depreciate your rental property if it meets all the following requirements:
- You own the property.
- You use the property in your business on income producing activity.
- The property has a determinable useful life.
- The property is expected to last more than 1 year.
Land Cannot be Depreciated
You can never depreciate the cost of land on your rental property because land does not wear out, become obsolete, or get used up.
The cost of clearing, grading, planting, and landscaping are usually all part of the cost of land and cannot be depreciated.
Rental Property Depreciation Recovery Period
For rental property placed in service after December 31, 1986 the depreciation cost is recovered over 27.5 years. Only the cost of the structure is allowed as a depreciation deduction; the value of land cannot be depreciated. If the property is used for commercial purposes, it must be depreciated over 39 years.
Rental property depreciation example: Doug purchase a piece of rental property for $300,000 in 2014 and put it on the market in June. The tax assessor for the county assessed the value of the land to be $100,000 and the house to be $200,000.
To determine the amount Doug can depreciation you will need to visit our MACRS depreciation table for 27.5 residential property to determine the percentage Doug can deduct in his first year. Doug started using the property for rental purposes in June, month 6, and using the table the resulting percentage is 1.970%.
Thus Doug must use the following calculation to determine his first year rental property depreciation deduction:
$200,000 house value X 1.970 = $3,940.
Doug can deduct $3,940 for 2014.
Beginning of Rental Property Depreciation Period
You begin to depreciate rental property when it is available for rent to tenants.
Rental property depreciation timing example 1: You purchase a house in March 2013 and spent April and May making repairs. The house is ready to rent in June and you begin advertising to find a tenant. You
may begin depreciation as of June. Even if a tenant doesn’t move in for another two months your start date is still June.
Rental property depreciation timing example 2: You bought a home and used it as your personal home several years before you converted it to rental property. Although its specific use was personal and no depreciation was allowable, you placed the home in service when you began using it as your home. You can claim a depreciation deduction in the year that you converted it to rental property because it’s use changed to an income-producing use at that time.
Adjusted Basis for Depreciation
Before you can figure the allowable depreciation, you may have to make certain adjustments (increases and decreases) to the tax basis of the property. The result of these adjustments to the basisis the adjusted basis.
Depreciation of Idle Property
You may claim a deprecation deduction on property used in your rental activity even if it is temporary idle (not in use). For example, if the house is empty while you are making repairs after a tenant moves out, you can still depreciate the rental property during the time it is not available for rent.
Claiming the Correct Amount of Rental Property Depreciation
You should claim the correct amount of depreciation each tax year. Even if you did not claim depreciation that you were entitled to deduct, you must still reduce your basis in the property by the full amount of depreciation that you could have deducted.
Rental Property Depreciation Common Mistake
One common mistake some taxpayers make is that they do not deduct depreciation on their investment property. If you make this mistake, correct it immediately by filing to take the past depreciation with your current tax return. You can amend your tax returns for the previous there years so that you can depreciate your properties on those returns (three years is the limit for amending past returns).
If you are not allowed to make the correction on an amended return, you can change your accounting method to claim the correct amount of depreciation. To change your accounting method, you must file Form 3115, Application for Change in Accounting Method. to get the consent of the IRS. In some instances, that consent is automatic. For more information, see Changing Your Accounting Method in IRS Publication 946 .
Rental Property Depreciation Recapture
Depreciation on a rental property reduces your basis for figuring a gain or loss on a later sale or exchange. If you have a gain on the sale of your rental property, part or all of the gain may be required to be “recaptured” as ordinary income that is completely taxable in the year of the sale. Depreciation recapture is taxed at a rate of 25%.
Rental Property Depreciation Example: Dan Bacon buys a rental property for $120,000. Over time he takes $25,000 in depreciation deductions. These deductions reduce his basis to $95,000 ($120,000 – $25,000). In 2014, Dan sells his rental property for $150,000. Dan’s gain is $55,000 ($150,000 – $95,000). The gain is comprised of two parts, $25,000 in depreciation deductions and $30,000 in excess of the purchase price. The $25,000 is counted as part of the taxable gain and taxed at a rate of 25%.
Note that the 25% tax rate is the maximum rate that can be taxed. So, if your personal income tax rate is 33%, for example, you are ahead 8%.
Important Note on Rental Property Depreciation
If you don’t take the depreciation when you should, the IRS will assume that you took it anyway. If you ever sell your investment property, you will have to pay tax on the recaptured depreciation even if there’s nothing to recapture. By not depreciating you will lose the tax savings while you own the property and you will have to pay taxes when you sell.
Section 179 Election