There are many benefits to owning residential rental properties: cash flow, appreciation and equity building. My favorite benefit, which offers a significant financial upside and can offset some or all of your rental income, is depreciation. While you may be familiar with some of the basic tax advantages and write offs of rental ownership, understanding depreciation and utilizing it is a game changer. More importantly, if you don’t use it you lose it!
Rental property depreciation is available if your investment property meets the following criteria:
- You own the property, even if there is a mortgage on it.
- Use the property as an investment and expect it to produce income.
- You expect the property to last more than one year.
Keep in mind, you can’t deduct any depreciation if you obtain and dispose of the property in the same year. You also can’t deduct depreciation on the land or the lot itself. For these purposes, land is considered permanent. Depreciation deductions are applied to the cost of the building and or the capital improvements made to a rental property. In order to determine how much of the property’s purchase price is for the structure and how much of the value is in the land, check out your county tax assessment which will include a breakdown of the assessed value of each.
In general, residential rental properties have a useful life expectancy of 27 ½ year. Although we are not addressing commercial property benefits today, commercial properties are depreciated over 39 years. Besides the purchase price of the property you can also depreciate improvements, additions, or other features that are added in order to make the property more viable or rentable. Other items such as legal fees, recording fees, property surveys, transfer taxes, and title insurance costs can be added to the cost basis. Travel related expenses to visit a potential rental property can be added to the cost basis only if you purchase the property. Travel to visit an existing rental would be tax deductible that year.
MAINTENANCE vs. IMPROVEMENTS
It is also very important to understand the difference between maintenance versus improvements. A roof repair, like using tar and shingles to fix a leak, is considered maintenance and is deductible only in the year that it occurs. A roof replacement is an improvement and is eligible for depreciation. Some improvements will have a useful life expectancy that differs from the 27 ½ years the rental property offers. For example, while hardwood flooring is
considered a long-term improvement and depreciates across the entire 27 1/2 years, new carpeting has a useful life of five years for depreciation purposes. There is no dollar limit on your potential deductible depreciation. The limit is based on the amount you have spent and you need to make sure you keep good records.
MEETING THE CRITERIA
You can continue to deduct rental property depreciation for benefits until one of the following criteria is
- You have deducted the entire cost basis of the property including: purchase fees, taxes
paid settlement, and any improvements you’ve made to make the property generate
- You stop using the property to generate rental income.
Keep in mind you are not required to deduct the value of depreciation for your rental
property each year. However, upon the sale of the property, whether it’s in a few years or
many years later, you will be required to re-capture the depreciation that was allowable on
the property while you owned it. Recapturing rental property depreciation means that you
must pay tax on the depreciation you were allowed even if you didn’t claim it! This would
be taxed at the ordinary income rate, but it’s capped at 25%. Therefore, it is definitely an
incentive to deduct the full amount of the allowable depreciation every year.
BENEFITS CALCULATION SCENARIO
If you were to purchase a property that cost $200,000 and through the tax assessment we concluded that the land was worth $20,000, that means you have $180,000 of a depreciable value. So, we are going to divide $180,000 by 27 ½ years which calculates to $6,545 a year in depreciation. In this example, let’s say the annual cash flow was $3,984. Cash flow on an annual basis is completely offset by the depreciation, making this a tax-free investment. Now, keep in mind, depending on the month that you acquire the property and place it in to service,
the depreciation would be pro-rated. The following full 12 months would be depreciated at the rate of 3.636% each year moving forward.
Keep in mind, passive losses can only go against passive income. However, passive losses can be carried forward year after year. If you qualify to become a real estate professional, your passive losses could go against your non-passive income. Just another way to save you more money on taxes.
An important part about being a successful passive investor is understanding the tax benefits that directly impacts profitability! Working with our team at Rent To Retirement, and having access to our strategic partners, will certainly benefit you when tax season approaches!