Cash flow is important when buying investment property. But there is another benefit to owning rental property that can help in a different way. It involves taking a deduction for capital depreciation on your taxes. Taking full advantage of these deductions can get a little complex, and getting advice from a good CPA is recommended, but we’ll layout basic foundation for you here.
Rental Property Depreciation
According to the IRS, depreciation is a capital expense. It is the mechanism for recovering your cost in an income-producing property and must be taken over the expected life of the property. You can begin to depreciate rental property when it is ready and available for rent.
Some investors look at depreciation like a phantom expense- it is not one you write a check for, but a perceived one based on the age, wear and tear of a property. You can also include improvements you’ve added to the land or made inside the property that are not part of the building like adding a bedroom, central air conditioning, appliances or a driveway, and depreciate those too. You cannot depreciate the land- only what is added to it.
Why would you want to keep track of improvements and add them to a depreciation schedule? Because it can reduce your reportable net income and therefore your taxes.
Calculating Depreciation
The IRS allows owners to take a tax deduction based on the perceived decrease in the value of the property over a period of 27.5 years for residential investment property (39 years for non-residential).
Depreciation is calculated with this formula:
Cost of the Building- Value of the Land = Building Value
Building Value / 27.5 = Yearly allowable depreciation deduction
It would look like this for a property worth $750,000 and land worth $250,000;
$750,000 – $250,000 = $500,000
$500,000 / 27.5 = $18,181
Cross Segregation
There may be instances where a landlord wants to speed up the time frame of depreciation, to take a bigger deduction sooner. Personal property and land improvements have shorter depreciation periods than the building itself, so those types of items can be depreciated on an accelerated schedule. A method called cross segregation allows items to be listed separately rather than grouping them together. It takes more work and attention to detail, but it means bigger total depreciation each year for the first several years you own the property, or taking the depreciation on accelerated schedule when you add features to the property.
The total deduction you can take doesn’t change but you will get it sooner, usually when it is more beneficial, than on the back end. You can take that monetary savings now and invest it, giving it more time to grow.
Make sure you are properly depreciating your property every year
If you didn’t know you could deduct it or forgot to, the IRS will assume it has been taken. When you sell, you may pay taxes on depreciation recapture that you never actually benefited from.
If you didn’t take a deduction for rental real estate depreciation in a past year, it’s not too late. Talk to your tax professional about filing an amended return and claim that lost depreciation.