Depreciation Of Rental Property: 5 Things Investors Need To Know

Posted on: 17 February 2015

If you buy a property as an investment, you expect to pay tax on any income the real estate makes, but you can also lessen your tax burden by claiming depreciation. The IRS allows property investors to offset the cost of depreciation through an annual allowance intended to acknowledge the cost of wear and tear. If you're new to real estate investment, or you just want to make sure you are accounting for depreciation on an existing rental property correctly, you should carefully consider the five following depreciation facts.

You can claim the allowance even if the value of your property increases

The IRS allows property investors to make a tax deduction against depreciation without considering the true market value of the property. On this basis, even if you purchase a property that increases in value over a ten-year period, you can still claim depreciation as a tax expense.

Some investors mistakenly believe that they can only claim depreciation when the market value of their property falls. In fact, the only question is how much depreciation you can claim. This calculation is rather more complicated, and depends on the expected recovery period, how much of the property you own and which method you choose to use. Nonetheless, these things aside, all investors can claim depreciation.

You can't choose to claim depreciation

When it comes to their tax deductions, property investors have no choice about depreciation. All investors must claim the depreciation allowance. Any tax return made without any account of depreciation is technically illegal. In fact, if you choose not to take tax depreciation, it could cost you more money in the long-term.

The IRS automatically assumes that your tax return includes depreciation. When you eventually decide to sell your property, the IRS will then decide if you must pay any depreciation recapture. The IRS will calculate this amount, assuming you have taken your full depreciation entitlement in preceding years. As such, you could end up with a depreciation recapture bill that is higher than the amount you owe because you haven't taken the deduction that the IRS thinks you should.

You can claim depreciation on a mortgaged property

According to the IRS, you can claim depreciation on a property that meets the following requirements:

  • You are the owner
  • You use the property to make an income
  • The property has a 'determinable useful life'
  • You expect to use the property in this way for at least a year

For the IRS's purposes, you are still the owner of a property that you have borrowed money to pay for. The depreciation allowance does not just apply to properties that investors buy outright.

Depreciation begins when you place the property in service, not when you first receive rent

To make sure you claim the right amount of depreciation, it's also important to understand what it means to place the property in service. In this case, the 'in service' definition means that the property is available to rent from a certain date. Of course, a property will often stay vacant for some time, but this makes no difference to the depreciation calculation.

As long as you advertise the property for rent, you can also carry out work during the depreciation period. For example, if you advertise a property with a realtor on January 1, it is then in service. If you spend time carrying out repairs in January and February and your tenant doesn't move in until March 1, the depreciation calculation still starts on January 1.

Indeed, the depreciation period continues after a tenant moves out, as long as the property remains available to rent.

You cannot depreciate the cost of land

While the IRS accepts that a property will deteriorate and lose value, the same definition does not apply to the land the building sits on. According to the IRS, land does not depreciate in value, as you can continue to reuse it as many times as you like.

If you buy a building and the price includes the land, you must split the total amount to claim depreciation solely on the cost of the building. This process is often complicated, and you may need to consult your accountant for further advice. This rule is one reason that many investors choose to buy apartments, as the cost does not generally include the land.

Real estate investors can offset some of their ongoing costs by claiming a tax deduction against property depreciation. That aside, it's important to seek professional advice because the depreciation calculation is complex and time-consuming to calculate. Click here for more info, or contact a local real estate investment company.