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Understanding Rental Property Depreciation

Depreciation is an annual tax deduction that allows taxpayers to recover the cost or other basis of certain property over the time they use the property. It is an allowance for the wear and tear, deterioration or obsolescence of the property.

For rental property, the depreciable life of your building is set by the IRS at 27.5 years for residential and 39 years for commercial property. You must separate the cost of the building and the land, since land is never depreciable. Buildings and certain land improvements are depreciated.

Sometimes you may have other asset classes such as appliances, HVAC systems and furniture that will be deducted over shorter time periods or even fully deducted in the year purchased using Section 179 or bonus depreciation.

What property is depreciable?

Small businesses (including Rental Property owners) can depreciate buildings, equipment, vehicles, and furniture. They cannot claim depreciation on personal property. If a business uses an asset, such as a car, for business and personal purposes the business owner can depreciate only the business use portion.

Businesses may depreciate property that meets all these requirements. The business must:

Own the property. The business is considered to own property even if it is subject to a debt. Mortgage payments are not a tax deduction, but the interest portion of the payment is deductible and in addition you can depreciate the cost of the building

Use the property in a business or income-producing activity. If the property is used to produce income, the income must be taxable. Property that’s used solely for personal activities can’t be depreciated.

Be able to assign a determinable useful life to the property. You do not need to depreciate costs of repairs such as painting, plumbing or general maintenance that are needed to keep your property in good working order. You only depreciate assets that have a useful life of more than a year or costs that improve the life of the property.

What is a repair vs an improvement? How do you tell the difference between the two? Here's a rule of thumb: An improvement is work that prolongs the life of the property, enhances its value or adapts it to a different use. An example of an improvement is a new roof or new HVAC system. On the other hand, a repair merely keeps property in efficient operating condition such as painting or roof repairs.

Depreciation is a great way to reduce taxable income but what is “Depreciation Recapture?”

Depreciation recapture is a process put in place by the IRS to recapture some of the deducted value of the property when you sell it. According to these rules, the amount deducted over time through depreciation is treated as capital gains which are taxed at a specific depreciation recapture rate when the property is sold.

When you sell your rental property, you pay tax on your gain. The portion of the gain that equals the depreciation recapture is taxed at your ordinary income tax rate or a maximum rate of 25%. The rest of the gain will be taxed at the long-term capital gains rate according to your income level. If you’re a higher-income taxpayer, you may also be on the hook for a 3.8% net investment income tax.

Let’s run through a simple example:

You buy a property for $500,000. You use it as a rental property for 10 years. You claim a depreciation deduction of $14,545 each year the property is in service. ($400,000 building and $100,000 land - $400,000/27.5 = $14,545)

The property then sells after 10 years for $750,000. Upon the sale of the property, you will need to pay capital gains tax on the profit. In this scenario, because you depreciated the property for 10 years you would make a profit of $250,000 plus the $14,545 x 10 years, making a total taxable capital gain of $395,450 ($250,000 + $145,450)

This taxable gain would then be subject to two different tax rates. $145,450 would be subject to the depreciation recapture rate of up to 25% and the remaining $250,000 would be subject to your long-term capital gains rate of 0%, 15%, or 20% depending on your income level.

Understanding the tax laws

This article explains the basis of depreciation and depreciation recapture. We encourage you to understand all of the favorable tax laws available to you as a real estate investor. We also highly recommend that you consult with a tax professional to make sure that you get the best return on your investment as possible and avoid any surprises.

Apex Virtual Accounting provides consulting services and tax preparation services for real estate investors. If you know somebody that would benefit from this information, please share. You can also sign up for our weekly newsletter so that you never miss an important tax update or tax advice.

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