Are you a real estate investor who owns rental properties? Even if so, you may have never taken depreciation into consideration when filing your taxes because it seems like it doesn't affect you.
However, depreciation is an important thing to calculate at tax time because the ability to deduct rental losses depends on whether or not the depreciation exceeds the property's adjusted basis. If you file your returns based on this idea and then get audited by the IRS, they will charge penalties for improper documentation of such deductions.
Since this issue is pretty complicated, we wanted to give clear-cut instructions about how you can take advantage of depreciation in order to make sure that your taxes are accurate and that those penalties are avoided.
What is depreciation?
Depreciation is an allowance provided through the IRS that allows you to deduct a portion of your property's value over its useful life. That's why it's called an "allowance." It allows you to take a deduction for the value of the property, even though the value decreases as time goes on.
For example, if you purchase a rental property for $100,000 and annual maintenance costs cost $5,000 (the proper maintenance of rental properties is key to creating positive cash flows), then your adjusted basis will be $95,000 ($100,000-$5,000).
If you sell that property for $110,000 after it has been in service for 5 years, then you will have a depreciation tax deduction of $6,500. In this example, the property's value is reduced by $10,500 ($95,000-$105,000), which is a tax credit that you can use to reduce your income taxes.
The depreciation deduction is determined on the basis of its useful life. If the property's useful life ends before its asset's value depreciates to zero (determined by a formula), then there will be no depreciation expense taken on the asset and you receive no tax benefit.
When you buy a rental property, you have some control over the amount of depreciation taken. You can choose to take a larger tax deduction when you first purchase the property, which reduces your taxes in that particular year but increases your tax bill for subsequent years because it is taking a larger percentage of the value each year. However, this will lower your annual property expenses so that there is more cash flow to work with.
What are depreciation methods?
The IRS has two depreciation methods: aggregate and straight-line depreciation. Straight-line allows you to deduct a constant portion of the asset's tax value each year and is the most common method used.
In order to figure out which method to use, you have to understand the class of your property. This is based on the date that your property was placed into service, which you must know in order to determine whether you can take depreciation.
What are the current rules?
The current guidelines for depreciation methods are as follows:
Property placed into service between 9/9/1997 and 12/31/2005 (inclusive): You must use the 150% declining balance method, with the half-year convention. For example, if you place a property into service in February 2007, then two years’ worth of depreciation would be deducted ($30,000*3/12= $10,000).
If you place a property into service before 9/9/1997, then you must use the straight-line method, but with no half-year convention used.
Property placed into service after 12/31/2005: You must use the straight-line method.
What is the proper way to take depreciation?
Since you're an investor, you want to maximize your losses and get the most tax benefit out of them. Therefore, you need to use this property's adjusted basis in order to calculate depreciation properly.
The primary rule for taking depreciation is that you have to deduct one-half of a year's worth of depreciation on each item that depreciates. In order to calculate the proper amount of depreciation, you have to know when your property was placed into service and the useful life of your property.
How can I figure out how many years my property has been in service?
The IRS provides a form that you can use to help you determine how many years your rental property has been in service. You fill this out annually using Form 4562 as part of the "Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts." It is found at the IRS website under "See Form" under "Form 4562." You then use this information for each year you own rental properties. This form is completed once per year for each rental property that you own.
How do I figure out the useful life of my property?
The useful life is determined by the IRS based on industry averages, and these may change from year to year. You must look in the Federal Register for your property's class. This will tell you when it was placed into service and its useful life, as well as its adjusted basis.
How to avoid calculating depreciation incorrectly?
The IRS has strict guidelines to follow when taking tax deductions and credits. If you have not followed these guidelines correctly, then you may be subject to relatively stiff fines for doing so. For this reason, it is crucial to be up-to-date regarding your depreciation when you are filing. If you have goofed at some point during the year, then we can help ensure that the IRS doesn't catch on.
If you have figures from a previous year that are significantly different from yours, then you need to go back to the IRS and get those adjusted figures before preparing your tax return for the current year. You do this by attaching Form 965 to your tax return. This form is available online through the IRS website as part of their instructions for how to file a Schedule E (Form 1040) - Supplemental Income and Loss. Have these forms ready before our experienced and friendly accountant can prepare your return.
What depreciate a rental property?
The real estate investment property would be viewed as a depreciating asset. The depreciation of the rental property is to lower the value of any gain in value that could occur during the first year. Setting up a depreciation schedule is part of how landlords handle rental properties in order to avoid under-declaring profit by deducting capital expenses from this total taxable income dollar for a dollar while determining gross rents per square foot and expensing those as well.
Under current tax rules, the rental property can be deducted from gross income as rent paid even if the property is owned by someone else. That means when a landlord owns the property, he or she can claim a deduction for it. However, when a landlord rents out that same property, any rental income would not be reported on any returns (taxes). The rental income would go straight to the landlord’s other taxable income.
The rental properties that are owned by landlords who rent them out are usually tax-exempt since they don’t pay federal taxes while the tenants must pay federal taxes on all of their incomes. They must pay federal taxes also on any additional income they earn from these properties. These include property taxes, insurance, utilities, repairs, and vacancies in case the rent is too high.
When a landlord owns a rental property and rents it out he or she can claim depreciation. Depreciation is used to account for the wear and tear that occurs in a rental property from normal use by tenants over time. With depreciation, a landlord doesn’t have to report all of the wear and tear on their rental as an expense or loss of income since it occurs gradually over time.
When a landlord rents out his or her own rental property, the depreciation is not separately reported on their return. But when a landlord rents out someone else’s rental property, they can claim the depreciation expense as a deduction from gross rents since it relates to the rental income.
Rental properties are also depreciated when an owner sells them at their fair market value less any mortgage. If the property was sold for $500,000 and there was a $100,000 mortgage on it then you figure if it was depreciated down by 20%. That would mean about $450,000 is what was paid for it.
Depreciation is commonly expressed in terms of the amount being deducted from an asset each year. That is to say that it’s allowed as a deduction annually on the asset’s taxable income. A landlord can deduct depreciation expenses for major improvements such as roofs, attics, and exterior walls. It also includes lesser types of work such as updating ornamental fixtures and painting interiors.
The IRS also allows landlords to claim a deduction for up to a maximum depreciation of $11,160 per year on any property acquired after 1986 in addition to depreciation on all other properties within the same lease. The depreciation rate is the percentage of income that would have been earned had the rental property not been depreciated over its useful life.
A landlord can also depreciate his or her own rental property if it’s being leased out and the landlord received a gain in connection with its sale. This means that at some point in time, a landlord might resell their home to make a profit. The IRS allows landlords to depreciate their rental properties over 20 years for capital improvements such as roofs and windows, but not for day-to-day maintenance such as landscaping and painting.
For more information, you can visit Real Estate Calculators.
