These include rental income, which acts as dividend income, as well as substantial tax benefits and expense write-offs, which can look like bonuses.

“Owning a rental property isn’t just about collecting rent or making long-term money on the sale of a property,” says Sara Lavdas, CFO of the Maryland and Delaware Group of Long and Foster Real Estate at Salisbury, Maryland.

Real estate investors who buy a property to rent it out to tenants as an income-generating business can amortize the cost of maintaining or improving a particular property, which offers attractive tax incentives. Here are some common questions about rental depreciation:

  • What is rental depreciation?
  • What are the tax advantages of depreciation?
  • How to declare depreciation?
  • How is it calculated?

What is rental depreciation?

The Internal Revenue Service defines depreciation as an annual tax deduction, allowing the investor to recoup the cost of certain properties while in use. This serves as an allowance for deterioration of a property that results in business expenses.

Straight-line depreciation is the most common form of depreciation, in which the value of the rental property is reduced evenly each year over the useful life of the asset.

“In the tax world, it is assumed that rental properties degrade over time and owners of rental properties are allowed to claim a tax deduction for a certain amount of the value of the property. calls depreciation, ”says Lavdas.

The rental property depreciation process involves writing off or subtracting rental property expenses from your annual tax returns. Depreciation of the property can help the landlord recover the costs of the income producing rental property through tax deductions on your income.

Your property may be depreciated if it meets certain requirements determined by the IRS: you own the property, you use the property in your business or income-generating activity, the property has a determinable useful life, and the property is expected to last more than a year.

Depending on the type of property, depreciation allowances are spread over 27.5 years for residential properties and up to 39 years for commercial properties, but this can vary. This is important for the calculation of depreciation. As stated by IRS rules, the depreciation method used by most taxpayers is the Modified Accelerated Cost Recovery System (MACRS). Under the direction of the IRS, the MACRS table lists asset classes with different depreciation periods, which helps determine the depreciation amount of a property.

One of the requirements of depreciation is to have a determinable useful life or a defined life, which means that the rental property normally wears out over time.

“Depreciation is an income tax deduction that allows an owner to recoup the cost of acquisition and make a property operational in order to collect income,” says Evi Kokalari-Angelakis, Founder and CEO of Golden Key Realty in New York.

Certain factors are excluded from depreciation. Kokalari-Angelakis mentions that the value of the land is not included since it does not depreciate.

The cost of the land will generally remain constant since it does not wear out or go out of fashion. Also, if you are a tenant and pay rent, the property in which you reside cannot be depreciated; only the owner of the residence can depreciate his property.

The course of depreciation of a rental property begins when it is first used as a means of collecting rental income, and the depreciation process ends when the rental service ends or when the landlord has perceived the value and expense of the property.

Some may confuse depreciation with a reduction in the value of an asset; however, depreciation does not characterize the loss of value of an asset. Rather, it is about taking into account the costs of ownership.

What are the tax advantages of depreciation?

The depreciation of a rental property can bring tax advantages to an investor and his real estate activity.

A huge incentive to invest in real estate is to lower your tax liability to save money on your taxes each year. To qualify for the tax benefits, you should have already spent money on the rental property.

“Any tax deduction can apply to all income tax deductions where the losses generated by real estate would offset the expenses of the business, thus reducing the tax obligations of any type of income,” said Julio Gonzalez , Founder and CEO of Engineered Tax Services in West Palm Beach. , Florida.

There are two different types of real estate investors: active and passive participants. This distinction is important because the IRS examines these characteristics to see if the participants are up to the requirements to deal with certain losses.

Taxpayers are considered active real estate professionals if they participate in more than 750 hours of service during the tax year in the real estate field.

Passive participants – usually referring to investors involved in passive activity through rental businesses, such as rent collection – only compensate for passive losses limited to passive income, where eligible hours of activity are lower. .

The components that can be reported as “depreciable” assets are those that add value to your rental properties and everything associated with their management.

Home improvements that add value to the property or your laptop used to track your rental business data are all acceptable, experts say.

The cost of renovations becomes part of the depreciation base along with some of the closing costs, says Kokalari-Angelakis.

These deductibles should have a minimum shelf life of one year and gradually lose value over time.

How to calculate depreciation

The amount of depreciation is determined by several factors, including the estimated value of the land as well as the value of the building or residential property.

Typically, rental properties depreciate at a rate of about 3.6% for 27.5 years for residential properties, according to the IRS.

Determining the value of the property may not seem complex, but estimating the value of the land can be difficult, experts say.

As the land is not depreciable, investors are required to separate the value of the property from the value of the land.

“People are wary of this and it is a mistake because it can cause legality issues,” Lavdas said. “Let’s say you bought a property for $ 1 million. It’s reasonable to estimate that the value is around 10% in the field, but since this isn’t always the case, you need to get a third-party document (like a tax assessment) to back up that number. “

Kokalari-Angelakis says you need to determine the full value of the cost of the property, including purchase and closing costs and any home improvements, when calculating depreciation. In addition, the value of the land must be determined and deducted.

“Don’t start depreciation until the property is ready to be rented out,” Kokalari-Angelakis emphasizes.

Once the fundamental components have been determined, finding the amount of depreciation is a simple calculation.

Depreciation equals the purchase cost plus closing costs and adding home improvements before subtracting the value of the land and then dividing it by the depreciable life.

The value of the property divided by the number of years of depreciable life gives the amount of the tax burden that can be depreciated on an annual basis.

For example, a real estate investor who purchases a residential property valued at $ 150,000 determines the amount of depreciation by dividing $ 150,000 by 27.5, which makes nearly $ 5,455, the annual tax deductible amount.

Depreciation must be filed within one year, otherwise you will miss the opportunity for tax benefits. Either you use it or you lose it.

In recent years, Lavdas says tax laws have allowed homeowners to benefit from large additional deductions by taking a closer look at the different parts of the property that depreciate.

“You do it by having a cost segregation analysis done by a professional. It costs money, but it can pay off if you’re strategic about it,” she says.

An important part of the process can include a cost segregation study. In this analysis, a consultant examines the rental property to determine if there are parts of it that can be classified as personal property in order to separate it from real estate.

Then, personal property will be listed in shorter amortization periods for increased amortization benefits outside of real estate and may accelerate the amortization benefit.

“Real estate agent Brandon Brittingham, owner of our business, performed a cost segregation analysis on a $ 7 million property.

How to Report Depreciation to the IRS

To depreciate a property, the owner must report rental income, expenses and losses to the IRS.

There are different IRS forms you need to fill out to list your total income, expenses, and depreciation for each rental property.

If you have more than one rental property, you must enter the depreciation you claim for each property, as required by the IRS.

Reporting all of these details can seem overwhelming to new real estate investors, as certain investment rules need to be determined. Some investors don’t know how to apply all the rules, which makes real estate investing more complicated, Gonzalez says.

If you’re a new real estate investor, finding a good accountant or a certified public accountant (CPA) firm can help you navigate the maze of rules.



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