For many rental property owners, tax breaks are a significant success factor, so it’s essential to come up with innovative solutions. Depreciation, in this case, helps immensely to maximize tax benefits and stay in accordance with IRS requirements. Knowing that you can deduct a portion of the building’s annual wear and tear when renting out a property comes in handy as a nice little tax trick. Because your property depreciates over time, it’s similar to receiving a prize.
With this tax deduction, property owners can potentially reduce their annual tax burden by thousands of dollars. However, navigating the complexities of rental property depreciation necessitates paying close attention to the regulations and building a depreciation schedule. Read along as we guide you through all these concepts and other essential details.
The Basis of Rental Property Depreciation
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Structure
For rental properties, the basis for depreciation is the property’s original cost basis plus any adjustments that have been made, including improvements, minus the land value. The IRS has established depreciation rules under MACRS for building and improvements on residential rental properties for a period of 27.5 years using a straight-line method. Partner with a Baltimore property management company to help ensure you maximize your tax breaks and maintain full compliance. The 27.5-year depreciation period reflects how the property can generate income as it experiences normal wear and tear, not the total purchase price.
The original cost basis is the total of all expenditures related to the purchase of the property, less the land value determined by the local government through either an assessment or an appraisal. When converting personal property to rental property, you can use the lower of the adjusted cost basis or the FMV of the property when converting. To calculate depreciation for a given period of time, divide the depreciable basis by the number of years in the depreciation period to determine the annual depreciation. You will prorate the depreciation by the time in the first year and the last year.
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Land Valuation
Another important aspect of a property’s value for depreciation on rental property is the land portion. Since land does not depreciate over time, it must be separated from the total value of the property when determining depreciation. The IRS provides guidance for separating land from property improvements through various methods of allocating values to separate components of a property, including tax assessments, appraisal values, and value ratios. The separate allocation of land from property improvements provides owners with a method for claiming depreciation on their properties and the depreciable personal property associated with the properties, such as buildings and equipment.
There are several ways to estimate the value of the land component of a property, such as using the county tax assessor to estimate the land value. For example, if an owner purchased a $400,000 home, of which $100,000 of the total price represents the land component, the remaining $300,000 of the purchase price may be depreciated. The depreciation for the $300,000 depreciable value would be approximately $10,909 for the first year.
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Eligibility Rules
To be eligible for depreciation, the property must be owned, used to generate rental income, and have a useful life greater than one year. Ownership includes properties with a mortgage, and converting a personal residence into a rental property will make it available for depreciation. Rentals can only begin or cease during the same tax year, and for residential real estate, 80% or more of the rental income must come from the dwelling units themselves.
The basis of a property will equal the total cost or adjusted basis at the time it is placed into rental service. The value of the real estate does not include land on which the real estate sits, as land cannot be depreciated. To determine the basis of a rental property that is converted from personal use, the lesser of the fair market value of the rental property when it is converted. Any capital improvements made to the property will be added to the basis. Any depreciation taken prior to the conversion, casualty losses, and certain credit amounts will be subtracted from the basis when a property is converted to a rental.
Navigating the Depreciation Schedule of the 27.5 Rule
For residential rental properties put into service after 1986, the 27.5-year residential rental property depreciation rule applies under MACRS using the straight line method and the mid-month convention. Under the 27.5-year depreciation rule, you are required to evenly distribute the depreciable basis of a residential rental property over 27.5 years, adjusting for the month in which you placed the property into service.
You will begin to claim depreciation on the month the property is placed into service, meaning when it is “ready and available for rent”. You will claim prorated depreciation for the first year. For example, if you placed your property into service in the middle of March, you would claim a deduction of 2.879% for the first year based on the full annual deduction of approximately 3.636% of your basis. Beginning with the second year, and every year thereafter until year 28, you will be able to claim full annual deductions in the same amount as your first year deduction and, therefore, recover your entire basis at that time.
The Property Manager’s Role in Depreciation Insight
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Strategic Improvement Coordination
Property managers help optimize the depreciation of rental property by coordinating improvements through capital expenditures that qualify for both an increased basis and rapid recovery. They also record significant upgrades as separate from repairs, which are immediately expensed, rather than depreciated over time.
It is important to maintain accurate records of all receipts and categorize capital improvements to increase the depreciable basis for tax purposes. It’s also important to conduct cost segregation studies for shorter-life property types to maximize deductions in shorter time frames. Timing improvements to coincide with tax years, as well as reducing vacancies, will result in properties being “in service.”
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Essential Communication Bridge
Through notifying the tenant of repairs that affect depreciable assets, management can avoid conflicts and maintain the value of the property through continuous tax deductions. This proactive measure will limit the amount of depreciation experienced through neglect by aligning operational insights with the right financial strategy.
The property manager will also keep a record of the purchase cost, whether the property is land or building, the value of any capital improvements made to the property, and the rental commencement date. All of this will be shared with the property owner in order for the property owner to accurately calculate their basis.
Final Thoughts
For landlords, rental property depreciation offers substantial tax benefits, but it necessitates meticulous record-keeping and close attention to detail. Understanding the fundamentals of depreciation can help you optimize your tax benefits while adhering to IRS laws, even though the principles may appear complicated. In the end, having a firm grasp of depreciation can help you lower your total tax obligation, enhance cash flow, and steer clear of unpleasant surprises like depreciation recapture when you sell your home.
