How Rental Property Depreciation is Explained
If you purchase a real estate property with the intent to rent it, there can be some significant tax advantages, like reporting rental property depreciation.
What is Rental Property Depreciation?
The IRS defines depreciation as a yearly tax deduction that allows the property owner to recover the cost of certain properties while they are being rented. This deduction serves as an allowance for the wear that is put on the property resulting in a need to spend money for repairs and upkeep (business expenses).
Straight-line depreciation is the most commonly used form of depreciation. Straight-line depreciation is when the value of the rental is evenly reduced each year over its useful lifetime.
A property needs to meet certain requirements determined by the IRS. Some of these requirements include having legal ownership of the property, the property is used for the purpose of making profit in a business or for income, the property has useful life and is expected to last more than a year.
Some factors of a property are not allowed to be used for depreciation tax benefits such as the cost of the actual land the property is on. A property owner also cannot use depreciation benefits if the property is not currently used as an income-producing rental. The course of depreciation can only begin after it is first being used as a rental.
Depreciation Tax Advantages
A large incentive to investing in real estate is lowering tax liability and saving money on yearly taxes. There are two types of real estate investors when It comes to tax filing: passive and active participants. This is an important distinction because classifying yourself as one or the other determines what requirements you will have to meet to be eligible for deductions.
An investor can qualify as an active participant if they have more than 750 hours of real estate investment work performed during the tax period. A passive participant is someone involved with passive activity in real estate investing such as collecting rent.
Some things that can be written off include closing costs on loans of purchase, a laptop used to track rent and expenses, and renovations.
The amount a property has depreciated is measured with several factors including the estimated value. On average, a rental property depreciates at a rate of around 3.6 percent for 27 and a half years for residential properties as stated by the IRS.
Determining a property value is not difficult, but where things can get hard is subtracting the land value from the total property value. This needs to be done when reporting depreciation for tax benefits. It is not uncommon for people to neglect to do this when filing tax reports, but it can lead to difficulties in legality. The best way to handle proving the land value is what it is and has been deducted is to get a third party documentation of the land value.
When the main property values have been determined, verified, and documented it is pretty simple to determine how much the structure has depreciated. First, know that depreciation equals buying costs plus closing costs and the costs of any improvements then subtracting out the land value and dividing that number by the depreciable lifespan. The resulting number is the amount that can be written or expensed off of your tax statement.
Depreciation amount needs to be filed within a year of the property being used as a rental or you miss out on the tax benefit. In some cases a property owner can write off more expenses by having a cost segregation analysis done by a professional leading to more deductions.
Reporting Depreciation on Tax Records
There are different forms to fill out for listing total income, expenses, and depreciation on each rental property owned. This can get overwhelming especially if you are new to investing. It is best to hire an accountant with rental property and real estate investment experience.
If you are looking to purchase a rental property in Columbus please contact us any time.