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Real Estate Tax Advantage #2 - Depreciation

What is depreciation?


Depreciation is a tax deduction – it lowers a person or an organization’s tax liability by lowering their taxable income. Three factors determine how much depreciation you can deduct each year:


  1. the basis in the property;

  2. the recovery period for the property; and

  3. the depreciation method used.


What Rental Properties & Expenses Can Be Depreciated?


As a rental property owner, you can deduct depreciation only on the part of your property used for rental purposes (meaning no depreciation for mortgage or principal payments, the cost of furniture, fixtures, equipment, etc.). If you are brave or IRS form savvy, check out Form 4562 to calculate your depreciation.


You can depreciate your property for tax purposes if the property meets all of the following requirements:


  1. You own the property (you are considered to be the owner even if the property is subject to a debt); you use the property in your business or income-producing activity (such as rental property);

  2. The property has a determinable useful life (meaning it is something that wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes); and

  3. The property is expected to last more than one year.


As you may already know, most rental property expenses including, but not limited to, mortgage insurance, property taxes, repair and maintenance expenses, home office expenses, insurance, professional services, and travel expenses related to management of your rental property are all deductible in the year you spent the money. Rental property depreciation works differently – rather than taking one large deduction in the year you purchase or improve a property, depreciation distributes the deduction across the useful life of the property.


What Rental Property Can’t Be Depreciated?


1. Land


As valuable as land can be, it is not your ticket to depreciation deductions. Reason being - you can’t depreciate the cost of land because land generally doesn’t wear out, become obsolete, or get used up. If it does, the loss in value may be accounted for upon disposition.


2. Excepted Property


Even if the property meets all the requirements listed above, you cannot depreciate the following property:


  1. Property placed in service and disposed of (or taken out of business use) in the same year, or

  2. Equipment used to build capital improvements. You must add otherwise allowable depreciation on the equipment during the period of construction to the basis of your improvements.


When Does Depreciation Begin and End?


Start – When the property is placed in service for the production of income (when the rental property is ready and available for a specific rental use).


Stop – Either when you have fully recovered your cost or other basis in the property, or when you retire it from service (i.e., when you sell or exchange the property, covert the property to personal use, abandon the property, or the property is destroyed), whichever happens sooner.


Depreciation Methods


Generally, for rental properties placed into service after 1986, you must use the Modified Accelerated Cost Recovery System (MACRS for “short”) for depreciation deductions. MACRS is an accounting technique that spreads costs and depreciation deductions over 27.5 years. This is the amount of time the IRS considers to be the “useful life” of a rental property.


For rental properties placed into service before 1986, you will use one of the following methods:


  1. The Accelerated Cost Recovery System (ACRS) for property placed in service after 1980 but before 1987, or

  2. The “straight line” or “declining balance” method over the useful life of property placed into service before 1981.


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