Real estate investing can provide a number of benefits to investors. One of these potential benefits is annual depreciation. The IRS allows investors to deduct depreciation as an expense once a property is placed into service. Because no asset lasts forever, depreciation is meant to capture the wear and tear of the property on an annual basis.
Depending on the asset, the amount of depreciation that can be deducted each year will vary. There are different depreciation systems but in the US, investors use the Modified Accelerated Cost Recovery System (MACRS) or straight-line depreciation.
Residential and commercial properties are also different asset classes, at least according to depreciation. It’s important to know that land cannot be depreciated — only the structure on the land.
What is Depreciation Schedule for Rental Properties?
A depreciation schedule in the context of rental properties is a document or report that outlines the systematic allocation of the cost of income-producing real estate assets over their estimated useful lives for tax purposes. Rental property owners use depreciation schedules to record and claim tax deductions based on the depreciation of their property and its components.
How a Depreciation Schedule for Rental Properties Works
A well-maintained depreciation schedule is crucial for rental property owners as it helps them maximize tax benefits by accurately reporting depreciation deductions. It’s often recommended to consult with a tax professional or accountant to ensure compliance with tax laws and to optimize the benefits of depreciation for rental property investments.
1. Initial Assessment
When a rental property is acquired, its cost is not solely attributed to the building itself. It also includes costs related to the land, improvements, and various components within the building (e.g., HVAC systems, appliances, roofing). A professional appraiser or qualified tax expert assesses the property’s components and assigns a value to each.
2. Depreciation Methods
There are two primary methods used for calculating depreciation in the context of rental properties: the straight-line method and the accelerated method (commonly referred to as the Modified Accelerated Cost Recovery System or MACRS in the United States).
Straight-Line Method: This method distributes the property’s depreciable value evenly over its estimated useful life. It’s a simple and commonly used approach.
Accelerated Method (MACRS): This method allows for more substantial deductions in the earlier years of the property’s life, followed by declining deductions in later years.
3. Useful Life and Recovery Periods
The IRS (Internal Revenue Service) in the United States has defined recovery periods for different types of rental property components. For example, residential rental property typically has a recovery period of 27.5 years, while non-residential property has a recovery period of 39 years.
4. Depreciation Calculation
Using the chosen depreciation method, the depreciation schedule calculates the annual depreciation deduction for each component of the rental property. This calculation factors in the component’s cost, its assigned recovery period, and the method applied.
5. Annual Reporting
Rental property owners include the calculated depreciation deductions from their depreciation schedule when filing their annual income tax returns. These deductions lower their taxable income, reducing the income subject to taxation.
6. Maintaining Records
It’s essential for rental property owners to maintain accurate records of their depreciation schedules and related expenses. This includes documentation of the property’s acquisition cost, improvements made over time, and any other costs relevant to depreciation calculations.
Examples of Depreciation Schedule
Residential Investment Property
As per IRS guidelines, it’s worth noting that residential property is assigned a shorter estimated useful life compared to commercial property. Investors are permitted to claim an annual depreciation deduction of 3.636% (which is equivalent to 1/27.5) for 27.5 years based on the property’s value.
To illustrate this, consider an investor’s purchase of a property valued at $500,000, with a land assessment of $50,000 and a structure assessment of $450,000.
Here is an example to demonstrate how the depreciation schedule is calculated:
$450,000 x 3.636% = $16,362 per year
It’s important to acknowledge that this example is simplified since it doesn’t factor in the cost basis. To determine the cost basis, investors should add any closing costs to the purchase price.
In continuation with the example, if you’ve owned the property for five years, you can claim a total depreciation of $16,362 x 5 = $81,810. However, it’s essential to be aware that upon selling the property, you might be subject to depreciation recapture.
In cases where the initial year of ownership does not encompass the full year, the investor will prorate the depreciation deduction for that period. Subsequently, for subsequent years, the full-year depreciation deduction can be taken.
There exist limitations on the amount of depreciation that investors can expense each year. For individuals with a modified adjusted gross income of $100,000 or less, the IRS permits a depreciation expense of up to $25,000. For incomes ranging up to $150,000, the allowable expense gradually decreases. Beyond an income of $150,000, depreciation expense is not permitted.
Commercial Investment Property
Commercial real estate (CRE) properties adhere to the same categories of depreciation deductions as residential properties, albeit with a longer estimated useful life. Instead of the 27.5-year duration applicable to residential properties, CRE properties span 39 years, equating to an annual depreciation rate of 2.56%.
For instance, if the property’s cost basis stands at $525,000, the yearly depreciation would amount to $13,440. Typically, a real estate tax accountant is responsible for maintaining and monitoring the depreciation schedule on behalf of an investor.
For more comprehensive insights into property depreciation, you can refer to IRS Publication 946.
By collaborating with a real estate accountant, you can ensure the precise utilization of the appropriate depreciation calculations and schedule tailored to your specific property investment.
How to Maintain a Depreciation Schedule
Maintaining a depreciation schedule for your rental property is essential for accurate financial reporting, maximizing tax deductions, and ensuring compliance with tax regulations. Here’s how to maintain a depreciation schedule effectively:
1. Establish a System
Set up a dedicated system or software to manage your depreciation schedule. Spreadsheet software like Microsoft Excel or specialized accounting software can be helpful.
2. Document Property Details
Record all essential details about your rental property, including the purchase date, purchase price, any closing costs, and details of any improvements or renovations made to the property over time.
3. Component Breakdown
List and categorize the various components of your property that are eligible for depreciation. This should include the building, appliances, HVAC systems, roofing, and any other depreciable assets. Each component should be assigned an estimated useful life.
4. Choose the Depreciation Method
Select the depreciation method that aligns with your financial goals and tax planning. Common methods include the straight-line method or the Modified Accelerated Cost Recovery System (MACRS) for tax purposes.
5. Calculate Annual Depreciation
For each depreciable component, calculate the annual depreciation deduction based on the chosen method. The formula will involve the component’s cost, its estimated useful life, and the depreciation rate.
6. Update Regularly
Keep your depreciation schedule up to date by recording any new property improvements, renovations, or changes in depreciation methods. Ensure that your records are accurate and comprehensive.
7. Consult Tax Professionals
Regularly consult with tax professionals or accountants who are well-versed in tax laws and property depreciation rules. They can provide guidance, review your depreciation schedule, and ensure that you’re maximizing tax benefits.
8. Secure Documentation
Keep all relevant documentation, including purchase receipts, invoices for improvements, and other financial records, organized and easily accessible. These documents will be crucial for supporting your depreciation claims in case of an audit.
Maintain a secure and organized record-keeping system for your depreciation schedule and related documents. Digital storage and cloud-based solutions can help ensure easy access and backup.
10. Tax Reporting
When it’s time to file your annual tax returns, include the depreciation deductions from your schedule. Accurate reporting is essential to reduce your taxable income and lower your tax liability.
11. Stay Informed
Stay informed about changes in tax laws and regulations that may impact depreciation rules. Tax laws can change, so it’s crucial to remain up-to-date to make informed decisions.
12. Periodic Review
Periodically review your depreciation schedule to ensure it aligns with your investment strategy and financial goals. Make adjustments as needed to optimize your tax benefits.
By following these steps and maintaining a well-organized depreciation schedule, you can not only reduce your tax liability but also ensure financial transparency and compliance with tax regulations for your rental property investments.