Depreciation in Real Estate
Depreciation in real estate is an important concept for property owners and investors. It’s actually extremely beneficial for those owners wanting to save a little money on their income taxes, among other things.
We’re going to dive into what depreciation on real estate is, how it’s connected to income (rental) properties, and how to calculate real estate depreciation.
What is Depreciation?
What is depreciation in real estate? All dwellings get run down, wear out, or fall apart over time, so savvy business and property owners know the importance of regularly spending money to maintain and repair properties they own. The good news, though, is the cost of maintenance and repairs can be at least partially offset by a deduction taken on tax returns known as depreciation.
Despite this relationship, depreciation is based on the purchase price of the property and its age, rather than the actual costs of repairs and maintenance.
Rental Property Depreciation
Depreciation comes in three forms: physical depreciation, functional obsolescence, and economic obsolescence.
Physical depreciation measures wear and tear on a physical building over time.
Functional obsolescence is tied to issues specific to the property, like design flaws or material quality issues.
Economic obsolescence has to do with issues beyond your property, like market fluctuations and price variations.
Can I Claim Rental Property Depreciation?
Depreciation on rental property can give owners a large tax break, but there are a few eligibility requirements:
- Ownership. To claim the depreciation you must, in fact, be the owner of the rental property.
- Income-Producing. The real estate must be used for business purposes. For a rental property, for example, the business is purchasing real estate that will be inhabited by tenants for a cost and amount of time determined and solidified through a contractual agreement.
- Determinable Useful Life. Real estate has a life span, meaning it’s something that wears out and has the potential to lose value over time.
- Useful Life Greater Than 1 Year. Even though real estate wears out over time, the idea is that the building will last for more than a single year.
When Does Depreciation Start?
When a real estate owner is ready to open their house/building for business purposes, depreciation can begin. Let’s say an owner decides their real estate is ready to rent on March 10th, but their first tenant contract agreement isn’t signed until May 10th. Even though the property was empty, depreciation can actually start on March 10th, since that was the date the business was ready to accept a “customer” (tenant).
How to Calculate Rental Depreciation
There is an accounting technique called the Modified Accelerated Cost Recovery System, and if your rental property became a business after 1986, you can use this system to calculate your depreciation. The method breaks depreciation down by year, and as per IRS code, it allows you to claim more depreciation in the early years of the property’s lifespan.
You can also use straight line depreciation real estate calculations. What is straight line depreciation? It simply deducts the same amount of depreciation every single year. Regardless of your calculation method, you’ll need to determine the cost basis before you can calculate annual depreciation.
1. Determine Cost Basis
Cost basis is the amount a real estate owner actually paid for a property, minus the cost of the land (if paid separately). This is used to calculate depreciation, which formally begins when the property is first put into service. Typically, residential rental property depreciation covers a period of 27.5 years.
2. Calculate Annual Depreciation
We discussed the accounting technique called the Modified Accelerated Cost Recovery System above, but there are a few more pieces to how depreciation can be determined.
The Modified Accelerated Cost Recovery System, or MACRS for short, is beneficial because it provides owners the opportunity to claim faster depreciation in the earlier years of their real estate business.
There are two different options with the MACRS:
- General Depreciation System (GDS). GDS is useful when an owner wants to claim depreciation on an aspect of their real estate business quickly. This means that a larger depreciation claim can be made in the first years of a business, and then in subsequent years depreciation amounts become smaller and smaller.
- Alternative Depreciation System (ADS). ADS is useful for spreading depreciation over a longer time span. This system is the IRS-approved form of straight line depreciation. A straight line rental depreciation calculator makes the math easy.
How Much Does Depreciation Save on Taxes
When you properly calculate depreciation on rental property you own, it can potentially save you thousands of dollars (or considerably more) in taxes each year of your business.
For example, let’s say you have a piece of real estate, and the dwelling is valued at $75,000. Using MACRS, your accountant has helped determine that your first-year depreciation is 2.273%. Your depreciation total for the tax year is determined by taking that percentage of the full amount, so $75,000 x 2.273%, which comes out to $1,704.75.
Depreciation is also determined by your tax bracket, so let’s say you’re in the 15% bracket. Take the depreciation we determined above, $1,704.75, and multiply that by 0.15 (or 15%) and you can save up to $255.71 in your first year.
Real estate depreciation allows owners to get a little relief from their taxes each year they operate as a business. It offers an opportunity to lower taxable income, which is beneficial for obvious reasons. For any business, big or small, saving on taxes can make a significant difference in overall profit – immediately and over time.
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