How to take depreciation and save money at tax time

Published: Sep 19, 2021

Stuff around the house breaks and wears down over time, and a home needs maintenance and repairs to keep it from deteriorating. Fortunately there is a tax break for rental property owners, that can help them pay for these inevitable expenses.

It’s called depreciation.

The IRS defines depreciation as “a capital expense” that “is the mechanism for recovering your cost in an income-producing property and must be taken over the expected life of the property.”

What this means in plain English is that some percentage of the cost of the rental property purchased can be deducted from an owner’s taxes each year. The IRS sets a period of 27.5 years for the life of a home, so the annual deduction once a property is put into service is 3.636 percent of the total cost. (There is a table of percentages monthly when a property is in use for only part of the year.) Multiplying the rental property’s depreciation expense by the marginal tax rate will calculate the property tax savings from real estate depreciation.

In short, the IRS allows a property owner a tax deduction based on the perceived decrease in the value of the real estate. 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.

What qualifies for depreciation?

The total cost of a property, also known as the basis, excludes the value of the land, which is not eligible for depreciation purposes  because land is never considered to be used up. For instance, 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. 

Additions or improvements can add to the basis of a property. This takes into all expenses, such as material and labor, but doesn’t include an owner’s labor. It also includes all expenses such as architect’s fees for plans to remodel a property, or the cost of a surveyor to install a fence on a lot line. Both expenses are considered part of the cost of the improvement.

How to calculate real estate depreciation savings in 3 steps

How to Take Depreciation and Save Money at Tax Time

The IRS says owners must 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 building value by 27.5 to get your depreciation expense.
  3. Multiply the depreciation expense by your marginal tax rate to get your tax savings from real estate depreciation.

Owners of rental homes can write off a variety of expenses

Aside from annual depreciation, there are a number of expenses associated with rentals that offer tax advantages. According to the IRS, the following are eligible for deductions in the year a landlord pays for them:

  • Advertising
  • Auto and travel expenses
  • Cleaning and maintenance
  • Commissions
  • Insurance
  • Interest (other)
  • Legal and other professional fees
  • Local transportation expenses
  • Management fees
  • Mortgage interest paid to banks, etc.
  • Points
  • Rental payments
  • Repairs
  • Taxes
  • Utilities

What type of property qualifies for depreciation?

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

  • You own the investment property.
  • You use the residential property in your 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.

The unique tax advantages of depreciation

Depreciation can be applied to both the residential property and improvements, but is not applied all at once because the value of these both extend beyond a single tax year. So rental property depreciation is spread over the useful life of the home or improvement.

When it comes to real estate, improvement and repairs refer to specific things and may be hard to distinguish. Here is a rule of thumb found in a guide from Mynd Management about the tax advantages of real estate:

  • Improvements: Add value to a home
  • Repairs: Return the house to its original condition.

To understand the difference, a good example is the type of work to maintain a roof. When a hole in a roof is patched, that is a repair; when it comes time to replace a roof, that is considered an improvement. 

How long can a property owner claim depreciation?

A depreciation deduction can be claimed on a property either of these conditions are met:

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

How much of tax deduction will depreciation realize?

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. The net gain or loss then goes on your 1040 form. Depreciation is one of the expenses an owner can include on Schedule E, so the amount of depreciation reduces tax liability for the year.

If there is a depreciation of say, $5,000, and a taxpayer is in the 22% tax bracket, that person would save $1,1000 ($5,000 x 0.22) in taxes that year.

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