Rental properties are a popular investment choice due to their potential for generating passive income and long-term wealth accumulation. However, as an investor, it is crucial to understand the concept of depreciation and how it can benefit your tax situation. Depreciation allows you to deduct a portion of the property’s value over time, reducing your taxable income and ultimately saving you money. In this article, we will explore how to compute depreciation on rental property and answer some frequently asked questions related to this topic.
What Is Depreciation?
Depreciation is a tax accounting method for deducting the cost of an asset over its useful life. Since rental properties are considered assets, they can be depreciated.
How to Compute Depreciation on Rental Property?
The most common method for computing depreciation on rental property is the Modified Accelerated Cost Recovery System (MACRS). This method allows you to deduct a portion of the property’s cost each year for a specified period, typically 27.5 years for residential properties and 39 years for commercial properties.
To compute depreciation using MACRS, follow these steps:
1. Determine the property’s basis: This is the original purchase price of the property plus any settlement fees, closing costs, or improvements made.
2. Subtract the cost of the land: Land is not depreciable, so you need to determine the value of the land separately and subtract it from the basis.
3. Determine the recovery period: Residential rental properties have a recovery period of 27.5 years, while commercial properties have a recovery period of 39 years.
4. Apply the depreciation rate: Refer to the IRS Publication 946 to find the depreciation rate based on the recovery period. This publication provides detailed tables and guidelines to help you determine the annual depreciation amount.
5. Calculate the annual depreciation deduction: Multiply the depreciation rate by the depreciable basis (basis – land value) to determine the annual depreciation deduction.
6. Record the depreciation expense: Keep accurate records of your annual depreciation deductions for tax purposes.
Frequently Asked Questions about Depreciation on Rental Property
1. Is depreciation available for all types of rental properties?
Depreciation is available for both residential and commercial rental properties that generate income.
2. Can I depreciate the entire cost of the property?
No, you cannot depreciate the value of the land. Only the building and any improvements can be depreciated.
3. What happens if I make significant improvements to the property?
You can depreciate the cost of improvements separately from the original basis. Different assets within the property may have different depreciation schedules.
4. Is there a limit to how much I can depreciate each year?
No, there is no annual limit on depreciation deductions; however, depreciation deductions cannot create or increase a tax loss.
5. Can I accelerate the depreciation deduction?
Yes, you may be eligible to accelerate depreciation through methods like bonus depreciation or cost segregation analysis. Consult with a tax professional to understand your options.
6. Can I claim depreciation if my property is not rented out for the entire year?
Yes, you can still claim depreciation for the portion of the year the property is available for rent, even if it remains vacant.
7. Can I claim depreciation on my primary residence?
No, you cannot claim depreciation on your primary residence since it is not being used for rental purposes.
8. What happens if I sell a rental property on which I have claimed depreciation?
When you sell a rental property, the depreciation you claimed will be subject to depreciation recapture, which means you may have to pay taxes on the amount you deducted.
9. Can I claim depreciation if I use the property for both rental and personal purposes?
Yes, but you can only depreciate the portion of the property that is used for rental purposes.
10. What happens if I stop renting out the property?
You can no longer claim depreciation once you stop renting out the property unless you convert it to personal use.
11. How does depreciation benefit my taxes?
Depreciation reduces your taxable income, which in turn lowers your overall tax liability, allowing you to save money.
12. Should I consult a tax professional to compute depreciation on my rental property?
While it is possible to compute depreciation on your own, seeking the guidance of a tax professional is recommended to ensure accuracy and take advantage of all available deductions and strategies.