Rental property depreciation: A comprehensive guide for accountants

This post will delve into the technical aspects of rental property depreciation to provide accountants with a comprehensive understanding of this essential concept.

What is rental property depreciation?

Rental property depreciation is a tax deduction method used by property owners and real estate investors to recover the cost of their investment property over time. It acknowledges the wear and tear of the property and allows for a gradual reduction in its value. This reduction in property value is considered an expense, which can be deducted from the property owner's taxable income.

When you own a rental property, the Internal Revenue Service (IRS) allows you to claim depreciation as an annual expense. The property's initial purchase price, excluding the value of the land, is divided by a set number of years (27.5 years for residential properties and 39 years for commercial properties) to calculate the yearly depreciation deduction. This deduction reduces your taxable income, ultimately lowering your tax liability.

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Benefits of rental property depreciation

Rental property depreciation offers a myriad of benefits for property owners and real estate investors. Here are the top advantages:

• Tax savings - Depreciation allows property owners to deduct a portion of their property's value from their taxable income each year, resulting in lower tax liabilities.¹
• Improved cash flow - By reducing the amount of income subject to taxation, depreciation enhances cash flow, providing property owners with more money to reinvest in their properties or pursue new investments.
• Cost recovery - Depreciation acknowledges the gradual wear and tear of a property over time, enabling property owners to recoup the initial investment made in purchasing or improving the property.
• Asset preservation - Depreciation encourages property owners to set aside funds for ongoing maintenance and necessary upgrades, ensuring the property's long-term value and sustainability.²
• Wealth accumulation - Over time, the cumulative tax savings from depreciation can be substantial, contributing to the growth of property owners' overall wealth.
• Risk mitigation - By reducing tax burdens, depreciation helps mitigate financial risks associated with property ownership, making real estate investments more appealing and sustainable.
• Economic incentives - Some governments offer incentives for property investment, such as accelerated depreciation schedules for energy-efficient improvements, further boosting the benefits of rental property depreciation.³

Depreciable real estate categories

When it comes to rental property depreciation, understanding the categories of depreciable real estate is crucial. These include:

Residential properties

• Single-family homes: Typically depreciated over 27.5 years.
• Multi-family units: Apartments and duplexes, often depreciated over the same 27.5-year period.
• Condominiums: Similar to multi-family units, depreciation is spread over 27.5 years.

Commercial properties

• Office buildings: Typically depreciated over 39 years.
• Retail spaces: Malls and storefronts, also depreciated over 39 years.
• Industrial facilities: Warehouses and manufacturing plants, typically depreciated over 39 years.
• Special-use properties: Properties like hotels and casinos may have unique depreciation schedules.

Depreciation assessment guidelines

Depreciation assessment guidelines are essential to determine and track depreciation expenses. 

1. Regular property assessment: Conduct regular assessments of your rental property to evaluate its condition and identify any wear and tear. This helps ensure that depreciation is calculated accurately.
2. IRS guidelines: Familiarize yourself with the Internal Revenue Service (IRS) guidelines regarding depreciation methods, recovery periods, and applicable conventions. The IRS provides clear instructions on how to calculate depreciation for various types of property.
3. Cost segregation study: Consider conducting a cost segregation study, especially for commercial properties. This study can help identify specific components of the property that may be eligible for accelerated depreciation, potentially increasing your tax deductions.
4. Documentation: Maintain meticulous records of your property's purchase price, acquisition costs, and any improvements made over time. These records are essential for accurate depreciation calculations and for providing evidence of the IRS with an audit.
5. Asset tracking software: Utilize asset tracking software or accounting software that specializes in property management. These tools can help automate depreciation calculations, track changes in property value, and generate reports for tax purposes.
6. Depreciation recapture: Be aware of the concept of depreciation recapture, which may come into play when you sell a depreciated property. Understanding how this works can help you plan for potential tax implications.

Filing rental property depreciation with the IRS

Filing rental property depreciation with the IRS is a crucial part of maintaining accurate financial records and maximizing tax benefits.

• Complete IRS form 4562 - This form is specifically designed for reporting depreciation and amortization. It's essential to fill it out accurately and include all relevant details.
• Attach supporting documentation - Along with Form 4562, you should provide supporting documentation that substantiates your depreciation calculations. This might include receipts, invoices, and cost segregation reports.
• Calculate total depreciation deduction - Sum up your annual depreciation deductions for the tax year. This total represents the amount you're eligible to deduct from your taxable income.
• Include on your tax return - Report the calculated depreciation deduction on your income tax return. Depending on your filing status and the type of return you're submitting (e.g., individual, business), ensure it's included in the appropriate section.
• Stay compliant - It's crucial to remain compliant with IRS guidelines regarding depreciation. This includes using the correct depreciation method, adhering to specified recovery periods, and maintaining accurate records.
• Consult a tax professional - Given the complexities of tax laws and depreciation rules, it's advisable to consult a tax professional or accountant who specializes in real estate taxation. They can provide expert guidance, ensure compliance, and help you maximize your depreciation deductions.

Tax deductions for rental property depreciation

Tax deductions for rental property depreciation can significantly benefit property owners. Key points to consider:

• Depreciation Deduction: You can deduct the calculated depreciation expense from your taxable income.
• Passive Activity Rules: Ensure you comply with IRS passive activity loss rules.
• Recapture Tax: Be aware of potential recapture tax when selling a depreciated property.

Computing depreciation for rental property

Computing depreciation for rental property involves specific calculations and considerations. 

• Determine basis - Start with the property's purchase price, including any acquisition costs such as closing fees, legal fees, and real estate agent commissions. This total becomes your initial basis.
• Allocate costs - Separate the initial basis between the building or improvements and the land value. Land cannot be depreciated, so you'll only calculate depreciation on the building or improvements.
• Choose depreciation method - Decide on the depreciation method to use. The most common methods are the Straight-Line Method and the Modified Accelerated Cost Recovery System (MACRS). The MACRS method is used for federal income tax purposes.
• Useful life - Determine the property's useful life based on IRS guidelines. For residential rental properties, this is typically 27.5 years under MACRS. Commercial properties, on the other hand, have a useful life of 39 years.
• Claim deductions - Deduct the calculated depreciation amount annually on your tax return. This amount is subtracted from your taxable income, reducing your tax liability.
• Consider special rules - Be aware of any special rules or provisions that may apply, such as bonus depreciation for new assets or energy-efficient improvements that may qualify for accelerated depreciation.

Frequently asked questions 

Can I depreciate the land value of my rental property?

No, land does not depreciate. Only the buildings and improvements on the property can be depreciated.

Is depreciation mandatory for rental properties?

While it's not mandatory, claiming depreciation can significantly benefit property owners by reducing their tax liability.

What happens if I sell a depreciated rental property?

When selling a depreciated property, any claimed depreciation may be subject to recapture tax. This means you may have to pay back some of the tax benefits previously gained.

Can I amend previous tax returns to claim the depreciation I missed?

Yes, you can amend previous tax returns to claim missed depreciation deductions, but there are limitations on how far back you can go.

If I deplete my cost basis with depreciation, won’t I have to pay capital gains taxes on the proceeds from a future sale of the property?

Yes, if you've fully depreciated your property, your cost basis will be reduced to zero. When you sell the property, you may be subject to capital gains taxes on the proceeds exceeding your adjusted basis.

What IRS forms do I file in order to claim depreciation?

To claim depreciation, you should complete IRS Form 4562, which is used to report depreciation and amortization. Attach this form to your tax return when filing.

Sources:

1. Venkataraman, P. (2021, June 14). The Tax Benefits of Depreciation for Private Real Estate Investors. Origin Investments. https://origininvestments.com/depreciation-tax-benefits-private-real-estate/
2. Folger, J. (2022, March 11). How Rental Property Depreciation Works. Investopedia. https://www.investopedia.com/articles/investing/060815/how-rental-property-depreciation-works.asp
3. Following the Government’s Playbook: Tax Incentives for CRE Investments. (n.d.). JD Supra. Retrieved September 4, 2023, from https://www.jdsupra.com/legalnews/following-the-government-s-playbook-tax-5055174/