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 greatly lessen the taxable rental income amount that you report 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 period of time you continue to use depreciation depends on a couple of things— 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). Generally, MACRS is used for any residential rental property placed in service after 1986. If you use this method then the cost to purchase and improve a rental property is spread out over 27.5 years, which is what the IRS considers to be the “useful life” of a rental house.
To find out how much your depreciation should be each year, there are a few things you’ll need. You’ll need to know 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 get the amount that’s just for your rental house, you’ll need one more step. That is to figure out your adjusted basis. A basis in a rental property can be modified 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. Beginning with your adjusted basis, you can now 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. This is why 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 Greater Milwaukee, we can connect you with accounting professionals who can help you solve your depreciation questions and more. Our experts can help property owners make sure that you are prepared and there are no unpleasant surprises at tax time. To know more about what our West Bend property management services can do for you, please contact us online or give us a ring at 262-309-6961.