A quick summary
Real estate depreciation can be a huge tax benefit for investors, both for residential and commercial real estate. If you’re planning on purchasing a rental property soon, you might be wondering when and how to go about depreciating it. So, we’ll answer the question, when does depreciation start?
Main Topics
We all know that real estate typically appreciates in value over time, but depreciation is also an important element to real estate investing. A quick reminder, rental property depreciation is extremely useful for investors because they can get a tax deduction on the price of the property, as well as any improvements that have been done to it. This means that they can reduce taxable income by spreading the depreciation across the useful life of the property, instead of being done as one deduction when you purchase the property.
We’ll delve into more detail on how to depreciate rental property, when you can start depreciating rental property, and how to calculate it.
When does rental property depreciation start?
Once a rental property meets the basic criteria set out by the IRS, you can begin depreciating as soon as the property is available as a rental or is in service generating income. The IRS outlines the following criteria for determining if you can depreciate a property:
- You need to be the owner of the property.
- You are using the property for an income-generating activity, or for business purposes.
- The property must have a determinable useful life span based on the type of property it is, and the rate at which it will wear down.
- The property’s useful lifespan must be more than 1 year.
How long can you depreciate a rental property?
There are 2 methods to use for depreciation, either the General Depreciation System (GDS) or the Alternative Depreciation System (ADS). Generally, you can choose to use either one, for both residential rental property and commercial property. ADS is only mandatory under specific circumstances.
There’s no way of knowing how long a rental property will be in use for, so the IRS has come up with set periods of depreciation.
Depreciation schedule for rental property
The GDS stipulates that the lifespan for a residential property is 27.5 years. So, how much does a property depreciate per year? For each year that the property is in service you can depreciate 3.636%, provided that the depreciation continues. However, if you begin depreciation at a point where the property was in service for less than 1 year, you’d depreciate a smaller percentage that year depending on the month.
Depreciation schedule for commercial property
Commercial properties have a lifespan of 39 years under the GDS. So, you can depreciate them for this period of time, or until one of the circumstances below is met.
You can continue to depreciate a property until:
- You have finished deducting the entire cost basis or other basis from the property.
- The property is no longer being used for an income-generating activity, whether that means it’s sold, abandoned or anything else.
How do you calculate first year depreciation?
One of the most important numbers to work out when it comes to depreciation is cost basis. The cost basis is the net acquisition cost of an asset. How does it differ from the purchase price? Cost basis includes origination fees, legal fees and other expenses, as well as any improvements that you do to the property to increase its value. Once you’ve worked out the cost basis, you can figure out your depreciation amount.
Another consideration is separating building and land values because you would usually depreciate these separately as only the building can be depreciated. One way to do this is by using the land’s market value from the appraiser at the date of the sale, so that you can work out how much of your purchase price was for the house itself and how much was for the land.
Your first year of depreciation is calculated using the following schedule, according to the IRS Residential Rental Property GDS table:
Property Depreciation Table
| Month | Depreciation |
|---|---|
| January | 3.485% |
| February | 3.182% |
| March | 2.879% |
| April | 2.576% |
| May | 2.273% |
| June | 1.970% |
| July | 1.667% |
| August | 1.364% |
| September | 1.061% |
| October | 0.758% |
| November | 0.455% |
| December | 0.152% |
For example:
If you bought a property for $200,000, your annual depreciation deduction would be $200,000 / 27.5 = $7272.
However, if you bought a house with a total basis of $100,000, and you began renting it out on August 1st your calculation for the first year would be:
$100,000 x 1.364% = $1,364
How to depreciate renovations
To calculate the depreciation on renovations, you would add up the total cost of the renovation and divide it by the depreciation period. It’s important to note that routine maintenance and repairs, property management fees and property tax cannot be depreciated.
For example:
If you made renovations to your property with a total cost of $50,000, you would divide this by 27.5 to work out the annual depreciation of the renovations, which would be $1,818. For commercial properties, this would be divided by 39.
Do you depreciate in the final year?
This will depend on if the property is still in service in the final year, and whether the cost basis has been fully deducted yet. When you sell your property however, the IRS will “recapture” the depreciation, which means that you’ll be subject to capital gains tax on the taxable income that you’ve managed to reduce during that time.
Fore more info on this topic, you can read our detailed guide on what happens to depreciation when you sell a rental property.
FAQ
Depreciation begins as soon as your property becomes income-generating or is put in service. So, if you bought the property on the 1st of June, for example, but you only began renting it out on the 1st of August because you had to fix it up first, then you’d begin depreciation in August.
A primary residence cannot be depreciated, only properties that are used in service or being rented out and generating an income. In other words, investment properties that are being rented out or commercial properties that are being used for business purposes.
After all this, you might be wondering, do you have to depreciate rental property? The short answer is no, you’re not legally required to depreciate property. However, choosing not to depreciate is not usually in your benefit, as you could be saving thousands of dollars every year.
If you’re not sure how to depreciate correctly, it’s a good idea to research as much as you can and get a tax advisor to help you so that you don’t make any mistakes. Tax can be intimidating if you’re not sure how it works, but this particular process is worth the effort to save money.
Final thoughts
Property depreciation can be a useful tool for real estate investors to reduce their taxable income, and sometimes even eliminate it. However, it’s important to bear in mind that you’ll be subject to capital gains tax once you sell the property, so you’ll owe the lesser of your current tax bracket or 25% plus state income tax on any deprecation you claimed.
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