As a landlord, you might be able to reap the benefits of depreciation to reduce your tax liability. Depreciation is an IRS-allowed expense that lets you recover the cost of your rental property over time through annual deductions.
At its core, depreciation is a way to account for an asset’s gradual loss in value over time. This reduction in value can be caused by various factors, such as normal wear and tear or changes in market conditions. In this post, we’ll look more closely at the notion of depreciation and investigate some of the elements that influence how it’s computed.
To calculate your rental property depreciation, follow the following steps:
- Determine the basis of the property
- Separate the cost of land and buildings
- Determine your basis in the house
- Determine the adjusted basis, if necessary
1. Determine the Basis of the Property
Determining the basis of your property is the first step in computing depreciation. This figure will consist of the amount you paid for it and any costs or fees incurred during its purchase. You can deduct any closing costs, legal fees, real estate commissions, and other associated expenses from this total.
For example: Let’s say you paid $125,000 for your rental property, and you incurred $5,000 in closing costs. This would give you a basis of $120,000.
2. Separate the Cost of Land and Buildings
The cost of the land and the buildings on it will usually form the basis of your property. However, you can only depreciate the value of the buildings—the land is not subject to depreciation.
You’ll need to evaluate the buildings’ fair market value at the time of purchase to figure out how much of your base applies to them. You can do this by hiring an appraiser or using a similar method.
In our example, let’s say a recent real estate tax assessment values your property at $100,000, of which $80,000 is for the building and the remaining $20,000 applies to the land. As a result, you can dedicate 80% ($80,000/$100,000) of the purchase price to the house and 20 percent ($20,000/$100,000) to the land.
3. Determine Your Basis in the House
Now that you’ve separated the cost of the land and buildings, you can begin to calculate your depreciation deduction. To do this, you’ll need to determine your basis in the house—the portion of the purchase price that applies to the building itself.
As we mentioned earlier, your basis in the house is 80% of the total purchase price. In our example, this comes out to be $96,000 (80% of $120,000).
4. Determine the Adjusted Basis, if Necessary
If you’ve made any renovations or additions to your property, then the adjusted basis of your property is important to determine. This figure will reflect all increases in value from the date of purchase until the date that you begin depreciating your property.
In order to determine the adjusted basis, you’ll need to review your property’s tax records. Any improvements or additions you’ve made should be itemized on your tax return. Add up the total cost of these improvements to get your adjusted basis.
In our example, let’s say you’ve made $10,000 in improvements to your property since you purchased it. This would give you an adjusted basis of $130,000.
When Does Property Depreciation Starts?
Depreciation starts when the property is placed in service. This means that it’s ready and available for use. This will be the case when you initially begin renting out your property in most circumstances.
For example, You purchased a rental property on February 15. You’ve been working on the house for several months, and it’s finally ready to rent on April 1, so you start advertising online and in the local newspaper. You find a tenant, and the lease is set to begin on May 15. Since the property was placed in service—that is, ready to be leased and occupied—on April 1, you would start depreciating it in April rather than in May when you begin collecting rent.
You can continue to depreciate the property until one of the following conditions is met:
- The property is fully depreciated, meaning it reaches the end of its useful life.
- You sell or dispose of the property.
- You stop using your rental for business purposes and begin to use it for personal purposes instead.
What Is the Formulation for Calculating Rental Property Depreciation?
The depreciation deduction for a rental property is calculated using the straight-line method. With this method, you take an equal amount of depreciation deduction each year over the useful life of the property.
For residential rental property, the useful life is 27.5 years. For commercial rental property, it’s 39 years. These lives are based on standard industry and IRS guidelines, but they can vary based on the specific property and its condition.
To calculate depreciation under the straight-line method, you simply take the total basis of your property and divide it by its useful life. Consider the following scenario: you purchase a $250,000 rental property with an adjusted basis of $200,000, you would divide $200,000 by 27.5 to get a depreciation deduction of $7,273 per year.
Note that while this method is most commonly used for calculating rental property depreciation, several other options are available, including the double-declining balance method and the 150% declining balance method.
Which of Your Property Is Depreciable?
The IRS states that you can depreciate a rental property if it meets all of the following criteria:
- You own the property.
- The property must have a usable life that extends beyond the current tax year, meaning it can’t be something that will only last for just one year, like seasonal decorations or furniture.
- The property must be utilized for business purposes in accordance with its intended use. This means that if you’re planning to rent out a vacation home, it’s not considered depreciable if you decide to use it yourself for part of the year.
- The property has a determinable useful life, which means it wears out, decays, is used up, becomes obsolete, or loses value due to natural causes.
It is crucial to note that even if the property fits all of the above criteria, it cannot be depreciated if it is placed in service and then disposed of or no longer used for business purposes in the same year.
Furthermore, the land is not depreciable because it is never “used up.” In general, the costs of clearing, planting, and landscaping cannot be depreciated because they are considered part of the land cost rather than the cost of the buildings.