A quick outline
Property depreciation can be a useful tool for real estate investors, however crunching the numbers correctly is important because the IRS often scrutinizes depreciation more than tax benefits. So, how much does a house depreciate per year? We’ll break it down for you and figure out the details.
Key Topics
We all know that property is one of the few assets that appreciates in value over time, but do you know about property depreciation? Unlike the name suggests, property depreciation isn’t all bad. In fact, for real estate investors it’s an important factor to consider when it comes to lowering tax liability. Depreciation is often a misunderstood concept so we’re going to demystify it and help you see how depreciation can be your ally in real estate investing.
What is property depreciation?
Property depreciation is the process of deducting certain costs when you buy or renovate a house. You can lower the amount of tax you need to pay by depreciating property and, as an investor, this can be a major benefit. Basically, you can deduct your expenses from any rental income that you earn from a property.
However, the expenses can’t be deducted all at once and must be split across the lifespan of the property. The IRS determines a property’s lifespan as 27.5 years, so over the course of this period you can claim back a portion of the initial cost of the property. The more that can be written off to tax over this period, the less tax investors will need to pay.
For rental property investors, depreciation can offer a welcome advantage to the passive income that they’re earning. The IRS has a particular set of criteria for this however, so investors will need to brush up on this before writing off expenses as “depreciation losses”. The main requirement is that only properties that are used for business purposes can claim depreciation, because the house (asset) is seen as a business or investment which earns an income.
Which types of properties can be depreciated?
The IRS has certain criteria that need to be met, in order to claim depreciation on it. These are the criteria for investors:
- The owner of the home must be you, even if you have a mortgage or loan on it.
- The asset (property) is expected to last more than 12 months. This is also true for improvements made on the house, for example a new roof would have a lifespan of over 12 months.
- You use the property for business purposes or to generate an income.
- The property has a particular useful lifespan that can be determined, which means that it can wear out, decay, or lose value from natural causes over time.
If you sell the house within the year or are no longer using it for business or income-generating purposes, then you will not be able to claim depreciation.
How much does a house depreciate per year?
The amount that a house depreciates each year hinges on 3 factors; the depreciation method that you are using, your cost basis in the property and the recovery period. A qualified tax accountant is the best person to assist with working out the depreciation of a house, but if you’d like to do it yourself, here’s how it works:
Step 1: Work out the cost basis of the house
The cost basis refers to the net acquisition cost of an asset, which means that it’s not just the price that you paid to purchase the property, whether that was with cash or a loan. It also includes any improvements that have been done to the property which increase its value, some settlement fees and closing costs. Bear in mind that any improvements that are made to the house simply to keep it in good working order, do not qualify here, and neither do all the settlement fees and closing costs.
The following settlement and closing costs are included in the cost basis:
- Legal fees
- Recording fees
- Surveys
- Transfer taxes
- Title insurance
For example, if you were to purchase a house that cost $300,000 and the origination fees, legal fees and other applicable costs came to $10,000, your cost basis would total $310,000.
Step 2: Distinguishing between land and house
It’s important to work out the cost of the land and the house separately because you can only depreciate the building itself, and not the land. There are 2 ways you can do this:
- Use the fair market value from an appraiser for the land or the house for the date of the sale. You can subtract, to work out the value of the either the land or house if you can only get one value. For example, if the land cost $50,000 at the time of purchase, but you paid $250,000 for the property, then the building itself was $200,000.
- You can use the property’s most recent real estate tax assessment values, which separate land and building values.
Step 3: Your cost basis in the house
Figuring out what your cost basis in the house is, is important because depreciation affects the cost basis of your investment. Which means that as you deduct depreciations over time, your cost basis will reduce. For example, if you own a house and your net cost of the house was $200,000, your annual depreciation expense would be $7,273. After owning the house for 1 year, your cost basis would be reduced to $192,727, after 2 years to $185,454 and so on. Your cost basis could end up at zero by the end of the 27.5 year period, unless you made improvements to the house.
Step 4: Work out the adjusted basis
Over time, you will need to raise or lower your basis depending on what happens between when you buy it and when you begin renting it out or using it for business purposes. For example, if you have made any improvements that have a useful lifespan of over 1 year, these will add to your basis. Alternatively, if you have received any insurance payments due to theft or property damage, these will lower your cost basis.
How much does a house depreciate during the first year that you take ownership?
A home is said to depreciate by 3.636% per year if you’re using the General Depreciation System, assuming the useful lifespan of the house is 27.5 years. However, this number is specifically for homes that were in service for the full year. Homes that were bought or came into service for part of the year will only be able to depreciate a percentage of the average for that year which is a prorated deduction. Thereafter, they can claim the full depreciation percentage each year.
For example, according to the IRS, if you bought a house in January, you’d have a depreciation rate of 3.485%, or if you bought a house in September, you’d have a depreciation rate of 1.061%.
What happens after the depreciation period ends?
When it’s time to sell the property, the IRS will require a form of capital gains tax called depreciation recapture. While depreciation can be great for investors as they can save a lot on tax, if you’ve owned the property for a long time, this can be a disadvantage when it comes time to sell the property, particularly if you sell it for much more than you initially bought it for.
The capital gain refers to the difference between the net sale price and your cost basis, and this amount is taxed at a capital gains tax rate. Which means that any amount of the sale price that shows a gain over your depreciated cost basis will be taxed a flat rate of 25% as depreciation recapture.
This simple guide provides more detail about what happens to depreciation when you sell a rental property.
How do you adjust the depreciation amount if home renovations are completed?
Any expenses that are incurred after the property purchase has been made and renting has begun can be depreciated separately to the purchase price of the property. In other words, if the renovations were done after the property is being rented out, you can depreciate these, but it cannot fall under the same depreciation as your purchase price.
Some examples of renovations that can be depreciated are:
- Roof replacement
- Kitchen remodel
- Bathroom remodel
- Replacement of windows
- Landscaping improvements
- Septic tank replacement
- Electrical system overhaul
- Property maintenance equipment
Some renovations have the same depreciation period as the building itself, ie: 27.5 years for rental property and apartment buildings. However, other renovations need to be depreciated within the same year that they are completed. So, it’s important to get assistance with this process from an accountant, to make sure that you’re depreciating your renovations correctly.
To depreciate a renovation you can use the total cost of the renovation and divide it by the depreciation period. For example, if you built an addition to a house that costed $50,000, you would divide that by 27.5 and your annual depreciation would then be $1,818.
FAQ
You do not have to be a business owner to claim depreciation necessarily, however the property needs to be used for income generation (renting it out) or for business purposes. You will need to be the property owner and the property will need to have a determinable useful lifespan, in order to meet the basic IRS requirements for claiming depreciation on it.
You can only claim depreciation on your primary residence if you are using areas of it exclusively for business purposes. In other words, those who work from home can claim depreciation on the area of their home where they work, or those who rent out a room can claim depreciation on that room. The IRS also requires that you prove that it is your primary residence.
Closing thoughts
For real estate investors who are investing in rental properties, depreciation can be a useful tool to save on tax and lower your monthly costs. However, bear in mind that when you sell the property again, you may be liable for depreciation recapture tax. A tax accountant is your best bet to help you navigate the process of property depreciation.