What Is Depreciation in Real Estate?

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Understanding and effectively utilizing the concept of depreciation is crucial for those involved in real estate. It can help protect your gross income and provide tax benefits. Our comprehensive guide explains what depreciation means, how it applies to real estate, and the advantages it offers.

Depreciation is a financial strategy used by businesses to spread the cost of an asset over its useful life. This allows for annual deductions and potential tax savings. It applies to physical assets like real estate, machinery, and equipment.

As assets age and newer models are introduced, depreciation considers wear and tear, inflation, and market value changes. Property owners can benefit from real estate depreciation by reducing their taxable income and increasing cash flow.

Depreciation schedules determine the annual deduction percentage based on the property’s purchase price and lifespan. Straight-line depreciation and accelerated methods are commonly employed. Straight-line depreciation deducts a consistent amount each year, while accelerated methods allow for larger deductions initially.

Calculating depreciation requires knowledge of the asset’s cost basis, useful life, and salvage value.

A Certified Public Accountant can help determine the best depreciation strategy for your business.

Understanding and following IRS rules for real estate depreciation is crucial. To calculate and claim deductions, refer to IRS Publication 946. Include depreciation deductions in your tax return at the end of the fiscal year. Depreciation ends when you remove the property from service or fully recover its cost at the end of its allowable life (27.5 years for residential rentals).

To qualify for real estate depreciation, the property must meet certain criteria:

  1. You must own the property.
  2. The property must be used for business or income-generating activities.
  3. It should have a clear useful lifespan of more than a year.

Real estate used for leasing, such as vacation rentals, typically meets these criteria. Even mortgaged properties can qualify for depreciation. However, properties acquired for fix-and-flip purposes do not qualify as they are usually sold within a year without being leased.

The IRS uses the Modified Accelerated Cost Recovery System (MACRS) to calculate depreciation deductions. There are two systems under MACRS: the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). Real estate falls under GDS, but you may need to use ADS depending on your circumstances. Consult IRS Section 179 publication or a tax professional for guidance.

Under GDS, residential rental property earns 80% or more of its gross rental income from dwelling units, excluding hotels, motels, or transient properties. This system uses the declining-balance method, applying the depreciation rate against the non-depreciated balance. Residential rental properties have a useful life of 27.5 years, allowing owners to deduct the cost basis over this period.

The basis of your property is the amount used to calculate depreciation deductions. It typically includes costs deductible as business expenses in the year of purchase, such as legal fees, title insurance, and mortgage loan points. For real estate, it also includes your down payment and any assumed debt. When you start leasing a property you already own for business use, the basis is either the fair market value at that time or the adjusted basis based on the original cost plus adjustments for previous expenses.

Remember, the IRS has strict rules regarding real estate deductions. If you have doubts or questions about depreciating a rental property, consult a tax professional. Depreciation starts when you begin using the property for business or when it is marketed for rent. Upgrades and renovations done before this period do not count.

The IRS also has clear rules about changes to the property’s market value due to renovations and repairs before it’s put in service. Improvements in the first year can be deducted in that same year. After that, treat any repairs or improvements as separate depreciable items.

Even if you rent your vacation home part-time, you can still apply for a tax deduction as long as its primary purpose is income generation. Accurately divide your rental and personal expenses and maintain excellent records of the rental use. Any rental property in service for less than 15 days isn’t considered to have generated rental income and won’t qualify for a depreciation deduction.

Land cannot be depreciated as it doesn’t wear out over time like a home or building. Improvements that increase the value of the land, such as landscaping, pools, or fences, also can’t be depreciated, but these costs can be claimed on your taxes in other ways.

When selling an asset, depreciation recapture is an important consideration. If you’ve claimed depreciation for a property and make a profit from its sale, the IRS treats it as a reduction of your past income tax burden. You’re then required to treat the profit as ordinary income, taxed at a higher rate than capital gains. This is how the IRS recovers its depreciation loss. To avoid depreciation recapture, you can opt for a 1031 exchange, also known as a like-kind exchange.

Depreciation offers significant tax advantages by reducing your tax bill for the year. This expense is deductible from the total rent collected, similar to operating expenses like property management fees. This allows landlords to retain more money for greater long-term savings.

Maximizing Real Estate Investments: Understanding Depreciation and Reducing Tax Obligations

Understanding depreciation is crucial for landlords to optimize earnings and reduce tax obligations. By utilizing this accounting strategy, they can significantly lower their tax liabilities and maximize real estate investments for the long term. If you’re unsure about your situation, consider consulting a tax accountant or financial advisor. 

Our analysis provides information and does not substitute personalized advice. Start your journey towards reduced tax liability with a smart real estate investment. Explore our platform for property listings. Please note that the views expressed here are purely informational and may change over time. Refer to Foothold’s disclaimers for more details.

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