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The Rental Property Depreciation Allowance Calculation
Rental property depreciation (also known as cost recovery) is one of the biggest tax deduction benefits real estate investors get from owning a rental property.
The beauty of the rental property depreciation allowance lies in the fact that it is simply a “paper loss” that a real estate investor can write off during each year of owning the rental property without spending a dime out of pocket.
An investor can legally deduct the amount for depreciation each year as cost recovery from the cash flow collected from the property during the previous twelve month ownership period and thereby reduce his or her tax liability for the previous year. But, unlike say mortgage interest (which is also a legal tax deduction), real estate investors never have to pay for depreciation on rental properties.
In this article, we will discuss rental property depreciation; Includes its concept, limitations, applications and formula.
The concept of tax depreciation deduction is based on a principal known as “useful life”. The idea is straightforward. No matter how magnificent and prestigious a building is when it is built, any physical structure has a physical life and it wears out, deteriorates or becomes obsolete over time. In other words, brick and mortar is finite and can realistically last only so many years.
Furthermore (as a result of this deterioration), the owner is suffering a financial loss from owning the property (because it is deteriorating) and should therefore be entitled to “recover the cost” from his or her income tax. A result of the diminishing useful life of the asset.
This is the purpose of IRS Form 4562. So a rental property owner can claim tax depreciation deduction on any rental property owned by him for the last twelve months.
Fair enough. So the IRS has some limitations for real estate investors who try to claim this tax deduction for rental income properties they own.
For a taxpayer to be allowed a rental property depreciation deduction, the property must meet at least the following requirements:
- The taxpayer must use the property in a business or income-producing activity (personal residence does not count).
- The asset must have a definite useful life of more than one year.
- An asset cannot be placed in service and disposed of in the same year.
Similarly, the tax deduction for depreciation applies only to the physical structures of the property (called “improvements”), not to the land itself. There is no cost recovery allowance for cost of land.
Moreover, depreciation begins when the taxpayer places the property in service for use in producing income (ie, takes title) and ends when the taxpayer has fully recovered the cost or other basis of the property or when the taxpayer retires it. servitude (ie, transferred title); Whichever happens first. In other words, you will not get a tax depreciation deduction after the “useful life” of your income property is over or after you sell it.
OK, so what is a “useful life”?
Useful life is a term used by the IRS to specify the number of useful years it attributes to a rental property before it reaches the allowable depreciation deduction. However, useful life is used strictly for tax purposes only and does not indicate the actual physical life of a physical asset. In this case, the tax code currently considers the useful life to be 27.5 years for residential property and 39 years for non-residential property.
For example, a building that derives all or nearly all (80% or more) of its income from residential units such as single-family homes, multi-family, apartment buildings, condos, and the like is residential and thus can be depreciated for 27.5 years. . Assets deriving income from non-residential sources such as offices, retail space and industrial tenancies are non-residential and incur 39 years of depreciation.
Here is the calculation.
For our purposes, we’ll refer to the annual depreciation allowance and ignore what the tax code calls the “mid-month convention.” This convention applies to the year the asset is brought into service and any year it is disposed of, and states that you are only allowed one-half of the depreciation normally allowed in any month the asset is purchased and then sold. We are only dealing with the depreciation tax allowance taken annually during the holding period between the purchase and sale.
First, determine the correct basis of depreciation. This is essentially the underlying value of the rental property’s improvements (remember, you can’t depreciate the land). Then divide that depreciable basis by what the current tax code attributes to the useful life of the rental property.
Depreciation Allowance (Annual) = Depreciable Base / Useful Life
For example, you purchased a duplex thirteen months ago for $500,000, of which you pay $400,000 for the building and $100,000 for the land. What is your annual depreciation allowance?
In this case the depreciable basis is $400,000, the useful life is 27.5 years because this is residential property and the mid-month convention does not apply because it is not in the year of purchase or sale.
Depreciation Allowance (Annual) = Depreciable Base / Useful Life
Depreciation Allowance (Annual) = 400,000 / 27.5 = 14,545
Of course, there’s more to rental property depreciation then what we’ve discussed here, such as the capital costs of acquisitions and additions or capital improvements to the property. But hopefully you get the idea. Of course, we strongly recommend that you always consult a qualified tax professional before making any real estate investment decisions.
Just so you know. Rental property depreciation is just one of dozens of real estate calculations that can be made and learned with online real estate calculators developed for this purpose.
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