If you are the owner of an investment property that you plan on letting out to tenants, it is in your best interests to claim rental property depreciation. This guide covers several questions that first time buy-and-hold investors may have about the benefits of depreciation, and how to claim it successfully.
Are you required to take depreciation on rental property?
In short, you are not legally required to depreciate rental property. However, choosing not to depreciate rental property is a massive financial mistake. It’s the equivalent of pouring a percentage of your rental property profits down the drain.
This is not an exaggeration. Property depreciation quite literally makes it possible to write off a percentage of the property’s value as a tax-deductible expense for over 27 years. The decision to voluntarily forego this tax saving would be an act of lunacy.
Here’s another way to think if it. If someone told you that you could save thousands of dollars a year by filling in a few forms correctly, would you fill in those forms? Choosing not to depreciate your property is the equivalent of choosing not save thousands of dollars per year, something an experienced buy-and-hold investor would never do.
What happens if you don't depreciate rental property?
In essence, you lose the opportunity to claim a massive tax benefit. If/when you decide to sell the property, you will still pay depreciation recapture tax, regardless of whether or not you claimed the depreciation during your tenure as the owner of the property.
In other words, if you don’t depreciate rental property, you are effectively punishing yourself financially. It’s hard to understand why anyone would do that on purpose.
The primary reason people ask this question is because they aren’t certain of the correct way to claim depreciation, and they are ultimately worried about making a mistake with their tax return.
The fear of making a tax return mistake is understandable, given that depreciation is a relatively complex tax topic and the consequences of making a mistake on your tax return can land you in trouble with the IRS. However, once you understand how the basic process works, it should put your mind at ease to know that you are legally entitled to claim this benefit, even if you need a tax advisor to help you out initially.
Does depreciation affect profit?
To understand just how big an impact depreciation can have on the profitability of your investment property, it will be helpful to use a relatively simple example.
Let’s imagine you own an investment property with the following basic characteristics:
- Annual Rental income of $48,000
- Annual operating expenses of $18,000
- Annual depreciation of $20,000
If you choose to apply depreciation, the taxable income from the property is $10,000.
If you choose not to apply depreciation, the taxable income from the property is $30,000.
Importantly, you can reduce your taxable income without any extra money coming out of your pocket. Depreciation is like a prepaid expense that you covered upfront when purchasing the property initially. You then claim back that expense over the useful life of the property.
As you can see from the example above, claiming depreciation increases the profitability of the property by reducing the tax expense that you are obliged to pay the IRS. By extension, depreciation can improve the cash flow status of a rental property and the ROI that a real estate investor can expect from rental income.
Can you skip a year of depreciation?
“If you’re not able to deduct your rental losses, the IRS allows you to carry the losses forward into future tax years to deduct against future rental profits.”
If this applies to you, you aren’t really skipping depreciation. Instead, you are postponing it to a time in the future when it may make more sense to apply the depreciation. On this point, it’s worth mentioning that you can carry the depreciation losses forward indefinitely. This means you could stack the depreciation total for a number of years, if you need to. You can then elect what portion of the stacked deprecation total that you would like to claim, in the year that you choose to apply it.
Tax Loss Carry Forward Example
Let’s assume your annual depreciation total is $10,000, and you apply a tax-loss carry forward 2 years in a row.
This leaves you with an accumulated total of $30,000 in the third year:
- Year 1 = $10,000
- Year 2 = $10,000
- Year 3 = $10,000
You now have the choice of how much depreciation you would like to claim.
If you choose to claim $20,000 in the third year, you can carry the balance of $10,000 into the 4th year, and so on and so forth.
This example should make it clear that you can use rental property depreciation to your advantage, even during years when you are making a net loss on the property, by banking the depreciation for future years rather than skipping it outright.
If this situation applies to you, it is important to keep extremely detailed records of all your property expenses, including how much you initially paid for the building, and how much money you’ve spent on renovations. It may also be in your best interests to speak to a tax advisor the first time you attempt a tax-loss carry forward with rental depreciation specifically. Even though it is perfectly legal to do this, it is important follow the guidelines set by the IRS as strictly as possible. A tax advisor can make this much easier for you, and help put your mind at ease.
It is also important to keep in mind that the total depreciation that you can claim is set by the cost basis of property (ie the value of the property, minus the value of the land). For instance, if the cost basis of the property is $200,000, you cannot claim more than this amount over the useful life the property (27.5 years for a residential building).
How do you write off depreciation on a rental property?
Once you start renting out the property, you are legally entitled to start claiming depreciation. Broadly speaking, there are two key steps that you need to follow.
- Firstly, you need to work out how much you can depreciate in each applicable tax year.
- Secondly you need to submit all the required documents to the IRS
Residential Property - Annual Depreciation
(Value of property – Value of land) / 27.5 Years
Commercial Property - Annual Depreciation
(Value of property – Value of land) / 36 Years
Residential Property Example
Imagine you purchased a property with the following characteristics:
- Value of property: $200,000.00
- Value of land: $50,000.00
- Annual Depreciation = ($200,000 – $50,000) / 27.5
- Annual Depreciation = $5,454.50
As you can see, it isn’t overly complex to workout the maximum depreciation that you can claim. However, there are a few nuances that you need to be aware of.
Key Point 1: The Amount that you can claim in the first year is impacted by the month that your tenants sign the rental contract (ie when the property is put into service)
Annual Depreciation Table
During First Year Of Ownership - Resdiential Property-
JAN - 3.485%
-
FEB - 3.182%
-
MAR - 2.879%
-
APR - 2.576%
-
MAY - 2.273%
-
JUN - 1.970%
-
JUL - 1.667%
-
AUG - 1.364%
-
SEP - 1.061%
-
OCT - 0.758%
-
NOV - 0.455%
-
DEC - 0.152%
Key Point 2: If you renovate the property, it will increase the total depreciation that you can claim.
So, if the value of the building is $175,000, and you spend $25,000 on renovations, you will be able to claim 3.485% of $200,000 for each year of the property’s useful life thereafter.
What happens to depreciation when you sell a rental property?
It is only when you sell a rental property that depreciation transforms from a financial ally to a financial foe.
During the buy-and-hold phase of the property, depreciation works in your favor, effectively increasing the profitability of the property by reducing your taxable rental income. However, when you sell, you are obligated to pay depreciation recapture tax.
Assuming that the property appreciated in value, you will pay two forms of tax when the property is sold.
- Depreciation Recapture Tax – This is capped at 25% (based on your ordinary income tax rate)
- Capital Gains Tax – This is either 0%, 15% or 20%, depending on your tax filing status and your marital status.
Importantly, you only pay depreciation recapture tax on the amount that you have claimed while owning the property.
So, if you’ve claimed $40,000 in depreciation during the course of your ownership and you are taxed at the maximum depreciation recapture tax rate (25%), you would pay $10,0000 in total when the rental property is sold.
If the property depreciated in value, you won’t pay capital gains tax (no capital was gained) and you also don’t pay depreciation tax.
Final Thoughts
Ultimately, investment property depreciation might seem like a complicated topic at first, but once you understand how much money it can save you as a buy-and-hold investor, it makes sense to claim this tax-deductible expense successfully. Even if you need to bring on a tax advisor to help you do so initially, their services will be easily covered by all the money that you can save by doing so.