Tax season is on the horizon, and it’s time to start thinking about filing your property taxes.
Where do you start?
If you recently acquired rental properties and aren’t sure how tax season will play out, you likely have a lot of concerns and worries.
However, one benefit of owning real estate is that you get to take advantage of rental property depreciation. Depreciation is your key to achieving high deductions so long as you file your taxes correctly.
Let’s dive into the basics of rental property depreciation for landlords and how you can use it to save money this upcoming tax season.
What is Depreciation?
In simple terms, depreciation is the gradual decline in value of something over time. This loss is due to the item or asset being worn out or used up over time.
Depreciation occurs slowly—over several years, and sometimes longer. For instance, items like computers or software subscriptions depreciate in as soon as 2-3 years. Large assets like homes, meanwhile, depreciate for several decades. The larger the asset, the longer it takes to depreciate.
Do Rental Properties Depreciate?
What about rental properties? Do they depreciate? The answer is yes – but it’s a little more complicated.
Like any other type of asset, rental properties depreciate over time—specifically, over 27.5 years.
However, unlike other types of property, rental properties can also appreciate. Properties appreciate by gaining value through improvements, alterations, or renovations that you contribute to the property.
This is one reason why rental properties are such great investments. In addition to their cash-flow potential, you can cause your rental property to appreciate, which will lead to higher returns when you sell.
Let’s return to the effects of depreciation. The IRS recognizes that rental properties depreciate and allows you to compensate for this decline in value through depreciation deductions.
Depreciation deductions are tax deductions you can take each year you own a property for a certain number of years. This means as your property gets older, you can deduct a portion of its cost from your taxable income.
Tax rental property deductions are some of the best tax deductions available for landlords. Less taxes means more funds available for you to reinvest in your portfolio.
Schedules and Recovery Periods
All types of property follow a depreciation schedule, set by the IRS. The rental property depreciation schedule determines how much you can deduct each year and how long you can continue taking those deductions.
Depreciation begins when you put your rental property “in service.” Typically, this is when your units are on the market and ready to rent (but not necessarily filled). Depreciation ends when you fully recover the property’s value or when you sell your property, whichever comes first.
How do you know when you’ve fully recovered your property’s value? The recovery period is the length of time a specific type of property is depreciated, set by the IRS. The recovery period for rental properties is 27.5 years. This means, when you buy a property, you can take depreciation deductions for it over the course of 27.5 years, or until you sell it.
Calculating Depreciation and Recapture
So far, you can see that rental property depreciation has a lot of perks for landlords. It helps you gain access to more capital in the short term, pay less taxes, and use those funds to reinvest and generate even more cash flow.
However, there’s one caveat to rental property depreciation that occurs when you sell—recapture.
Depreciation recapture is the IRS’s way of “recapturing” the taxes you avoided paying when your property actually appreciates, or gains value. In essence, recapture means that the profit you gain when you sell will be taxed at a higher rate than the general capital gains rate.
Remember that before you sell your property, you should ensure that you’ve settled everything necessary with your lender if necessary. A mortgage debt on your property will quickly show up on a prospective buyer’s property lien search and prevent the sale from going through.
Rental property depreciation is one of the best tax deductions landlords can take advantage of. By understanding how this deduction and recapture work, you’ll be prepared to reap the benefits of rental property depreciation.