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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 why it’s important for Dr. Phillips rental property owners to fully comprehend what depreciation is, how it affects your finances, 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. In other words, instead of a large lump-sum deduction, owners would be deducting a portion of their purchase and improvement costs (not operating or maintenance costs) each year for several years. This can considerably lower the amount of taxable rental income you write on your tax return, making depreciation worth the time it takes to calculate.

A property owner can begin taking depreciation deductions as soon as the rental property is placed in service, or stated another way: when it’s ready for rental. That is great news for property owners who have to deal with a vacancy right after purchase or during renovations. The length of time you continue to take that depreciation is determined by two factors: How long you own and use the property as a rental, and which depreciation method you use.

There are different depreciation methods you can use 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). Normally, 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 compute how much your depreciation should be each year, you’ll need to figure out 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 have the amount for the rental house alone, you’ll need to move a step more and figure out your adjusted basis. A basis in a rental property can be raised 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 may decrease as well, 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 begin 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 not very easy or simple. You need to keep updated because rental property tax laws can be complex and change quite a bit over time. Because of this circumstance, 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 South Orlando, 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. To know more about what our Dr. Phillips property management services can do for you, please contact us online or give us a ring at 407-982-2000.

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