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Depreciation De-Mystified: An Introduction to Rental Property Depreciation

Dollar Bill Origami of a HouseThere are certain financial benefits of investing in rental properties. A few of them take effect when tax time comes and investors get to deduct operating expenses, property taxes, and so on. And on top of that, there is another thing they can deduct— 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 bring about issues in the future. This is why it’s important for Shoreline 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 suggests that rental owners break the amount and spread 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 could dramatically reduce the amount you report as your taxable rental income. The huge effect this has on your tax return makes depreciation well worth the time it takes to calculate.

The owner of the property may begin taking depreciation deductions as soon as the rental property is placed in service, or in short: ready to receive tenants. That is welcome news for property owners who have to go through a vacancy, either right after buying the home or during renovations. The amount of years that you’d take the depreciation is set by two things. The first one is how long you own and use the property as a rental, and the second one is which depreciation method you use.

There are different depreciation methods. Each one can 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. This number is quite complicated because 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. Usually, you can use property tax values to calculate what amount of the purchase price should be designated for the house, or your accountant might elect to use a standard percentage.

Once you’ve figured out the amount just for the rental house, you’ll need to take a step further and figure out your adjusted basis. A basis in a rental property can be revised 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 likewise decrease 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 simple or straightforward since rental property tax laws can be complex and change quite a bit every so often. 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 employ Real Property Management Eclipse, we can have accounting professionals guide you through your depreciation questions and more. Our experts can help property owners make sure that you are ready and that there are no unpleasant surprises at tax time. If you want to know more about our Shoreline property management services, don’t hesitate to contact us online or call us at 425-209-0252.

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