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How to take depreciation and save money at tax time

Legal compliance & taxes

Homeowners learn early on the demands of maintenance and repairs to keep their property in good condition. Rental property owners have the same burden, but they qualify for a tax break designed to help cover the cost of these expenses.

It’s called depreciation.

Depreciation allows property owners to recover some costs of an income-producing property, which the IRS estimates has an average lifespan of 27.5 years. Once a property is put into use, owners are permitted an annual deduction of 3.636 percent of the total cost of the property

Annual depreciation is also used by business owners to deduct a percentage of the cost of a piece of equipment over a number of years, a tax break that encourages capital investment.

This proviso is based on the perceived depreciation of a property over time. Even if a property appreciates, an owner is still entitled to the tax break.

What is depreciation in real estate?

A property’s total cost (sometimes referred to as the basis) excludes the value of the land. If a single family home is purchased for $250,000, and the land value is $25,000, the basis for the purposes of depreciation deduction on taxes is $225,000.

Land is irrelevant for depreciation purposes, as land is always valuable.

To qualify for depreciation, a property must meet all the following requirements, according to the IRS:

  • The individual filing taxes must personally own the investment property.
  • The individual filing taxes must use the residential property in a business or income-producing activity (such as collecting rent).
  • The property has a determinable useful life.
  • The property is expected to last more than 1 year.

Depreciation is also relevant to a residential property’s general maintenance and improvements. While maintenance and improvements are similar, they have different definitions regarding the tax allowance for rental property owners.

Maintenance is a repair, meaning it returns the property to its original condition. For example, patching up a hole in a roof would be maintenance while replacing the roof would be considered an improvement. In general, improvements add to the overall property value.

The tax allowance that accompanies home improvements takes into account expenses, like materials and labor, but it does not factor in the owner’s time and labor.

How to calculate real estate depreciation savings in 3 steps

To calculate property tax savings from real estate depreciation, multiply the rental property’s depreciation expense by the marginal tax rate.

If there is a depreciation of say, $5,000, and a taxpayer is in the 22 percent tax bracket, that person would save $1,100 ($5,000 x 0.22) in taxes that year. The amount of depreciation reduces tax liability for the year.

An owner who earns income from single family rental typically reports income and expenses for each investment property on the appropriate line of Schedule E in an annual tax return, and records the net gains or losses on the 1040 form. An owner can record a depreciation expense on Schedule E.

In order to calculate real estate depreciation savings, the IRS recommends that owners use the Modified Accelerated Cost Recovery System (MACRS) to apply for tax relief for residential rental investment properties placed in service after 1986.

  1. Land and home prices together equal the value of real estate, but depreciation only applies to the home. The value of the land should be deducted from the property’s purchase price or fair market value.

  2. Land does not lose value or wear out, but the IRS allows depreciation for the useful life of a building. The time frame is 27.5 years for residential rental real estate and 39 years for commercial property. Divide the home’s value by 27.5 to get the depreciation expense.

  3. Multiply the depreciation expense by marginal tax rate to get the tax savings from real estate depreciation.

Home improvement in a white living room with lots of light

Depreciation is relevant to home improvement projects, like replacing a roof, or strengthening the structure. (Credit: Getty Images)

How long can a property owner claim depreciation?

An owner can claim a depreciation deduction until either of these conditions are met:

  • The entire cost, or the basis, of the property has been deducted.
  • A rental asset is retired from service, even if the cost has not been recovered.
  • A property is retired from service when it ceases to be an income-producing asset — or if it is sold, converted to personal use, abandoned, or destroyed.

What type of expenses can an owner write off

Rental home owners can write off many expenses in addition to factoring depreciation into their taxes. Aside from annual depreciation, there are some tax deductions that are available to rental property owners.

According to the IRS, the following are eligible for deductions in the year a landlord pays for them:

  • Advertising
  • Auto and travel expenses
  • Commissions
  • Insurance
  • Interest (other)
  • Legal and other professional fees
  • Local transportation expenses
  • Management fees
  • Rental payments
  • Repairs
  • Taxes
  • Utilities

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