Calculating the depreciation allowance for rental property

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Rental property depreciation (also known as cost recovery) is one of the biggest tax deduction benefits that real estate investors enjoy when owning rental properties.

The beauty of the rental property depreciation allowance lies in the fact that it is simply a “waste of paper” that the real estate investor can write off during each year the rental property is owned without having to fork out. a penny out of your pocket.

The investor can legally deduct a depreciation amount as cost recovery each year from the cash flow it earned from the asset during the last twelve months of ownership and therefore reduce its tax liability for the past year. But unlike, say, mortgage interest (which is also a statutory tax deduction), real estate investors never have to shell out money for rental property depreciation.

In this article, we will discuss rental property depreciation; including its concept, limits, application and formula.

The concept behind a deduction for tax depreciation is based on a principal known as “useful life.” The idea is simple. That no matter how large and prestigious a building is when it is built, any physical structure has a physical life and will eventually wear out, deteriorate, or become obsolete. In other words, brick and mortar is finite and can realistically only last so many years.

In addition (as a result of this deterioration), the owner is suffering a financial loss from owning the property (because it is deteriorating) and as such should be afforded the benefit of “recovering the cost” of his property taxes. rent as a result of the decrease in the useful life of the property.

This is the purpose of IRS Form 4562. Therefore, an owner of a rental income property can claim a deduction for tax depreciation on any rental property they have owned during the last twelve months.

Fair enough. So let’s consider some of the limitations the IRS has for real estate investors trying to get this tax deduction for the rental income properties they own.

In order for a taxpayer to take a rental property depreciation deduction, the property must meet at least the following requirements:

  • A taxpayer must use the property for business or an income-generating activity (a personal residence does not count).
  • The property must have a determinable useful life of more than one year.
  • The property cannot be commissioned and disposed of in the same year.

Also, the depreciation tax deduction only applies to the physical structures (called “improvements”) of the property, not the land. There is no cost recovery subsidy for the value of the land.

Additionally, depreciation begins when a taxpayer puts a property into service for use in producing income (i.e. takes title) and ceases to be depreciable when the taxpayer has fully recovered the cost of the property or other basis or when the taxpayer removes it from service (ie, transfer of title); The thing that happens first. In other words, you won’t get a tax depreciation deduction for your income property past its “useful life,” or after you sell it.

Okay, so what does “shelf life” mean?

Useful life is a term used by the IRS to specify the number of useful years it attributes to the rental property to arrive at the allowable depreciation deduction. However, the useful life is used strictly for tax purposes only and does not necessarily imply the actual physical life expectancy of the physical asset. In this case, the tax code currently considers the useful life of residential property as 27.5 years and that of non-residential property as 39 years.

For example, a building that derives all or almost all (80% or more) of its income from housing units such as single-family homes, multi-family homes, apartment buildings, condominiums, etc., is residential and therefore can be depreciated 27 ,5 years. . Properties that earn their income from non-residential sources, such as offices, business premises, and industrial tenants, are non-residential and therefore depreciated for 39 years.

Here is the calculation.

For our purposes, we will refer to an annual depreciation allowance and ignore what the tax code calls the “mid-month convention.” This convention applies to the year the asset is put into service and any year it is disposed of and states that you are allowed to take only half of the normally allowed depreciation for any month the property is purchased and then sold. We only deal with the depreciation tax allowance that is taken annually during the holding period between purchase and sale.

First, determine the depreciable basis. This is essentially the original value of the rental property improvements (remember, you can’t depreciate the land). Then divide that depreciable base by what the current tax code attributes to the useful life of the rental property.

Depreciation provision (annual) = depreciable basis / useful life

For example, suppose you bought a duplex thirteen months ago for $ 500,000, of which you attribute $ 400,000 to the building and $ 100,000 to the land. What is your annual depreciation allowance?

In this case, the depreciable base is $ 400,000, the useful life is 27.5 years because it is a residential property, and since it is neither in the year of purchase nor in the year of sale, the half-year convention does not apply. of month.

Depreciation provision (annual) = depreciable basis / useful life

Provision for depreciation (annual) = 400,000 / 27.5 = 14,545

Of course, there is much more to rental property depreciation than what we have discussed here, such as capitalized acquisition costs and capital additions or improvements to the property. But I hope you got the idea. Naturally, we strongly recommend that you always consult a qualified taxpayer before making any real estate investment decisions.

Just so you know. Rental property depreciation is just one of dozens of real estate calculations that can be done and learned with the online real estate calculator developed for this purpose.

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