What Is Rental Property Depreciation And How Does It Work? (2024)

FAQs

What Is Rental Property Depreciation And How Does It Work? ›

Rental property depreciation is a basic accounting principle that allows you to deduct the cost of a rental property over a set period of time. The Internal Revenue Service (IRS) assumes a rental property will lose a certain amount of value every year (typically 3.6%).

To calculate the annual amount of depreciation on a property, you'll divide the cost basis by the property's useful life. In our example, let's use our existing cost basis of $206,000 and divide by the GDS life span of 27.5 years. Your depreciation would be $7,490.91 per year, or 3.6% of the loan amount.

Depreciation expense taken by a real estate investor is recaptured when the property is sold. Depreciation recapture is taxed at an investor's ordinary income tax rate, up to a maximum of 25%. Remaining profits from the sale of a rental property are taxed at the capital gains tax rate of 0%, 15%, or 20%.

Class life is the number of years over which an asset can be depreciated. The tax law has defined a specific class life for each type of asset. Real Property is 39 year property, office furniture is 7 year property and autos and trucks are 5 year property. See Publication 946, How to Depreciate Property.

IRS Code Section 1250 states that depreciation must be recaptured if it is allowable for the property. So, even if you don't claim depreciation for the years you owned the property, you'll still have to pay tax on the gain when you decide to sell.

Some investors may be tempted to skip claiming depreciation to avoid the risk of depreciation recapture tax, but this generally won't succeed. The IRS assumes that you have taken a depreciation deduction. You will owe 25 percent of what you could have deducted as a “depreciation recapture” when you sell the property.

Depreciation deductions allow property owners to recover the cost of their property over time. For owners of residential rental property, the cost is typically recovered after 27.5 years.

Real estate depreciation is a method used to deduct market value loss and the costs of buying and improving a property over its useful life from your taxes. The IRS allows you to deduct a specific amount (typically 3.636%) from your taxable income every full year you own and rent a property.

When the fully depreciated asset is eventually disposed of, the accumulated depreciation account is debited and the asset account is credited in the amount of its original cost.

What happens if you don't take depreciation? ›

If you don't claim your depreciation deduction, you pay the total penalty upon the sale of the property but still forfeit any tax benefits while you own it. It's best to claim the deduction each year and plan accordingly, which can involve paying the total recapture tax or finding strategies to avoid it.

Depreciation recapture tax is calculated by multiplying the depreciation expense claimed by your current tax bracket rate or 25% (capped at this rate for high-income earners) and reported using Form 4797. The IRS also requires you to pay tax on capital gains.

Moving Back In to Save on Taxes

Moving back into your rental to claim the primary residence gain exclusion does not allow you to exclude your depreciation recapture, so you might still owe a hefty tax bill after moving back, depending on how much depreciation was deducted (IRS, 2023).

Is it better to depreciate or expense? In general, it's usually better to expense smaller, short-lived items and depreciate larger, long-term assets. Expensing an item immediately provides a larger tax deduction in the current year, which can be beneficial for smaller purchases or those with a short useful life.

Straight-line method: This is the most commonly used method for calculating depreciation. To calculate the value, the difference between the asset's cost and the expected salvage value is divided by the total number of years a company expects to use it.

A company's depreciation expense reduces the amount of taxable earnings, thus reducing the taxes owed.

Real estate depreciation is a method used to deduct market value loss and the costs of buying and improving a property over its useful life from your taxes. The IRS allows you to deduct a specific amount (typically 3.636%) from your taxable income every full year you own and rent a property.

Wage income is earned income and falls within the category of ordinary income. The IRS does not allow us to mix passive losses with ordinary income. So, it is not possible to offset ordinary income with rental property losses, whether those losses are due to depreciation or operating expenses.

Such tax deductions include property taxes, mortgage interest, repairs, operating expenses, and depreciation. Think of rental property depreciation as the deduction of part of the cost of the rental property over many years. Each year, you deduct a part of the cost until your cost is fully recovered.

Regular MACRS - Regular MACRS depreciates property in the 3, 5, 7, and 10 year classes using the 200 percent declining balance method with an automatic switch to the straight-line method in the IRS tables. Assets in the 15 and 20 year classes are depreciated using the 150 percent declining balance method.