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Depreciation De-Mystified: An Introduction to Rental Property Depreciation

Dollar Bill Origami of a HouseThere are some financial benefits of investing in rental properties. A number of them are actualized during tax time when investors get to deduct operating expenses, property taxes, and so on. But there’s one more thing investors can deduct, and that is depreciation. This key tax deduction works differently from the others because, by its nature, it must be calculated and applied differently. Also, failing to take a deduction for depreciation can lead to problems down the road. This is the reason why it’s important for Worcester rental property owners to know what depreciation is and why you should be deducting it on your taxes every year.

In terms of buying and improving rental properties, depreciation is the process used to deduct any associated costs. Rather than take one large deduction in the year the property was purchased or improved, the IRS has recommended that rental property owners should distribute those kinds of deductions over the useful life of the property. To put it another way, owners would not go with one large deduction on the date of purchase but will be deducting a portion of their purchase and improvement costs (not operating or maintenance costs) each year for several years. This can greatly lessen the taxable rental income amount that you report on your tax return, making depreciation worth the time it takes to calculate.

Property owners may begin taking depreciation deductions as soon as the rental property is placed in service, or in essence: ready to be used as a rental. That is certainly good news for property owners who have a vacancy right after buying the home or during renovations. The number of years you’d spread the depreciation cost depends on two things. First, how long you own and use the property as a rental, and second, which depreciation method you use.

There are different depreciation methods that use different approaches to determining the annual expense. You may use any of them to determine the amount you can deduct each year. But the most common one for residential rental properties is the Modified Accelerated Cost Recovery System (MACRS). Typically, MACRS is used for any residential rental property placed in service after 1986. By applying this method, the expenses incurred to buy and improve a rental property spread out over 27.5 years, which is what the IRS considers to be the “useful life” of a rental house.

To determine how much depreciation you can claim each year, you’ll need to have your basis in the property or the amount you paid for it. You may also be able to include some of your settlement fees, legal fees, title insurance, and other costs paid at the settlement. What makes this number somewhat complicated is that you’ll need to separate the cost of the land from the building since only the rental house itself – and not the land it is built on – can be depreciated. In most instances, you can use property tax values to help compute how much of the purchase price is for the house, or your accountant might elect to use a standard percentage.

As soon as you get the amount that’s just for your rental house, you’ll need one more step. That is to figure out your adjusted basis. A basis in a rental property could be adjusted to account for things like major improvements or additions, money spent restoring extensive damage, or the cost of connecting the property to local utility service providers. The basis can decrease, too, in the event of insurance payments you received to cover theft or damage and any casualty losses you took a deduction for already that were not covered by your insurance. Using your adjusted basis, you can start to calculate the amount of depreciation you can deduct on your income tax return.

Depreciation of a rental property is a valuable tool for investors looking to reduce their annual tax obligation. However, it’s a bit more complicated since rental property tax laws can be complex and change quite a bit every few years. Since this is the case, it’s best to work with a qualified tax accountant to ensure that depreciation is being calculated and applied correctly.

When you team up with Real Property Management Metro West-Worcester, we can connect you with accounting professionals who can help you solve your depreciation questions and more. Teaming up with our experts can help property owners make sure that there are no unpleasant surprises when tax time comes. Don’t hesitate to contact us online or give us a ring at 508-329-6000 to know more about what our Worcester property management services can do for you.

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