Real estate investors interested in earning the most profit from their rental properties should become familiar with the concept of depreciation and the tax implications of this accounting technique. Let’s take a look at what it is, why you should consider it, and the associated tax considerations.
What is depreciation?
According to the IRS, "depreciation is a capital expense. It is the mechanism for recovering your cost in an income-producing property and must be taken over the expected life of the property." Essentially, depreciation allows you to deduct the purchase and maintenance upgrades of a property from your taxes. Note depreciation only applies to the property structure – not the land on which it rests.
When considering an investment in Chapel Hill condos for sale, Raleigh homes for sale, or Durham houses for sale, remember you can claim depreciation for any property you own which generates income even if you owe a mortgage on it or are a stockholder in a co-op (in this case, only if you rent your co-op tenancy to others). You are now allowed to claim depreciation on a property you rent yourself.
Depreciation begins to apply as soon as your property is ready for rental usage, even if you do not yet have a tenant. As soon as the property is ready to be "placed in service," depreciation can be claimed. You can claim depreciation on the property while between tenants, even if you wait to relist while making necessary upgrades and repairs.
Depreciation stops applying as soon as any of the following is true:
- You've regained the cost of the structure in terms of total depreciation deducted to date.
- You sell the property or otherwise exchange it.
- You change the usage from rental to personal property usage.
- The property is otherwise retired from use through abandonment, destruction, and the like.
Depreciation of a structure applies over 27.5 years, with the cost basis of the property eventually reaching zero.
Why should you use depreciation accounting?
Depreciation allows you to claim deductions over the entire useful life of the property, which can positively impact your taxable income. As a non-cash expense, it is possible your investment in Chapel Hill condos for sale, Raleigh homes for sale, or Durham houses for sale will produce a high cash flow with a far less taxable income which helps lower your tax bill as well.
You can deduct not only the purchase of the structure when buying in Chapel Hill condos for sale, Raleigh homes for sale, or Durham houses for sale but also any improvements made from the date the property is placed in service to the date it is retired. Although you will have to determine the adjusted basis to only deduct the structure cost – not including the land purchased – this can still allow you to claim a significant tax deduction.
In terms of property improvements and upgrades, you can claim depreciation for office furniture and equipment, automobiles, appliances, flooring, the furniture you provide for the rental property, roads to access the property, including driveways and sidewalks if you are responsible for them, shrubs, fences, necessary utility components such water heater, pipes, and furnaces, and major upgrades such as a new roof or siding. The IRS provides a table indicating how many years you can spread the depreciation claims over for each type of property upgrade.
How does depreciation impact taxes on rental income?
To claim depreciation as a tax deduction, you must be the owner of the property, it must be used for income production such as a business or rental, and the structure must be expected to exist for more than one year from the date depreciation is claimed.
As mentioned above, depreciation ends when it is retired from service, including upon sale of the property, and the amount is recaptured. As an example, imagine you purchased a property for $300k, of which $100k was deemed to be the value of the land. After 28 years, you have depreciated the entire cost of the structure(s) in small increments each year. When you sell the property, you will be taxed on a gain of $200k.
For real estate investments made in 2022, such as the purchase of Chapel Hill condos for sale, Raleigh homes for sale, or Durham houses for sale, you will use the Modified Accelerated Cost Recovery System (MACRS) to calculate the depreciation of your property. The MACRS applies to depreciation claimed after 1986 for properties newly placed in service. To claim deductions under MACRS, you must choose either the GDS (General Depreciation System) or ADS (Alternative Depreciation System) method. In general, GDS is used unless local law requires ADS or you choose to use ADS at the recommendation of your tax professional.
ADS must be elected in the first year the property is listed as placed in service. This method allows you to use a straight line of depreciation, and the IRS offers a table illustrating the comparison between ADS and GDS depreciation recovery periods.
For GDS, there are multiple property classes that determine the method of depreciation to use, the recovery time frame, and the convention. Property classes include 3, 5, 7, 10, 15, and 20-year non-residential and residential rental properties. Conventions set the beginning and end of the recovery period and can be mid-month, mid-quarter, or half-year.
To calculate the deduction to claim, you can either use the convention and depreciation methods that apply over the property's recovery or the MACRS percentage tables. If you choose to use the percentage table, you must use it for the rest of the recovery period unless the basis of your property is altered. Exceptions include allowed depreciation or improvements depreciated as separate property line items in your claim. Looking at Residential Rental Property, the claimable percentage is impacted by the month the property was placed in use. The claimable amount varies by start month in year one, but subsequent years in service (2, 3, etc.) use the standard percentage for that year.
Depreciation calculation can be complicated, so it is best to discuss further implications on your taxable income with your tax professional. After meeting with your tax professional, if you are interested in a real estate investment purchase of Chapel Hill condos for sale, Raleigh homes for sale, or Durham houses for sale, contact Chris & Kevin Knapp for expert guidance.
