Rental Property can be an effective tax shelter due to Depreciation

One of the tax benefit of  owning a rental property is that you can deduct your income tax by claiming your property losing value, or “depreciating”.  Even over time, yout property are most likely to increase in value, or “appreciating”.  So you pay less tax on your rental income as a result of depreciation.

How to Determine Rental Property Depreciation

Three basic factors determine how much deprecation you may
deduct for your rental property:

  1. Basis in the property
  2. Recovery period for the property
  3. Depreciation method used

You can deduct depreciation only on the part of your property used for rental purposes.  If you rent a room in your house you can only deduct a percentage of the depreciation available.  If you rent a rental property, you may deduct the entire amount of depreciation available to you.  Depreciation reduces your basis for figuring gain or loss on a later sale or exchange.

Depreciation Requirements

You can depreciate your rental property if it meets all the following requirements:

  • You own the property.
  • You use the property in your business on income producing activity.
  • The property has a determinable useful life.
  • The property is expected to last more than 1 year.

Land Cannot be Depreciated

You can never depreciate the cost of land on your rental property
because land does not wear out, become obsolete, or get used up. 

The cost of clearing, grading, planting, and landscaping are usually all part of the cost of land and cannot be depreciated.

Depreciation Recovery Period

For rental property, the depreciation cost is recovered over 27.5
years.  Only the cost of the structure is allowed as a depreciation
deduction; the value of land cannot be depreciated.  If the property is used for commercial purposes, it must be depreciated over 39 years.

Example: if you purchase a piece of rental property for $130,000.
The tax assessor for the county assessed the value of the land to
be $30,000 and the house to be $100,000.  The recovery period for rental property is 27.5 years so you would divide the $100,000 by 27.5 resulting in $3636.36. 

Beginning of Depreciation Period

You begin to depreciate rental property when it is available for rent to tenants.

Example 1:  You purchase a house in March 2008 and spent April and May making repairs.  The house is ready to rent in June and you begin advertising to find a tenant.  You may begin depreciation as of June.  Even if a tenant doesn’t move in for another two months your start date is still June.

Example 2:  You bought a home and used it as your personal
home several years before you converted it to rental property.
Although its specific use was personal and no depreciation was
allowable, you placed the home in service when you began using
it as your home.  You can claim a depreciation deduction in the
year that you converted it to rental property because it’s use
changed to an income-producing use at that time.

Adjusted Basis for Depreciation


Before you can figure the allowable depreciation, you may have to
make certain adjustments (increases and decreases) to the tax
basis of the property.  The result of these adjustments to the basis is the adjusted basis.

Depreciation of Idle Property

You may claim a deprecation deduction on property used in your rental activity even if it is temporary idle (not in use).  For example, if the house is empty while you are making repairs after a tenant moves out, you can still depreciate the rental property during the time it is not available for rent. 

Depreciation Recapture for Rental Property

Depreciation on a rental property reduces your basis for figuring a gain or loss on a later sale or exchange.  If you have a gain on the
sale of your rental property, part or all of the gain may be required to be “recaptured” as ordinary income that is completely taxable in
the year of the sale.  Depreciation recapture is taxed at a rate of 25%.

Example:  You buys a rental property for $130,000.  Over time
he takes $30,000 in depreciation deductions.  These deductions reduce your basis to $100,000 ($130,000 – $30,000).  You sells his rental property for $140,000. Your gain is $40,000 ($140,000 – $100,000).  The gain is comprised of two parts, $30,000 in depreciation deductions and $10,000 in excess of the purchase price.  The $30,000 is counted as part of the taxable gain and taxed at a rate of 25%.

Note that the 25% tax rate is the maximum rate that can be taxed.  So, if your personal income tax rate is 33%, for example, you are ahead 8%.

Claiming the Correct Amount of Depreciation


You should claim the correct amount of depreciation each tax year.  Even if you did not claim depreciation that you were entitled to deduct, you must still reduce your basis in the property by the full amount of depreciation that you could have deducted. 

Common Mistake 

One common mistake some taxpayers make is that they do not
deduct depreciation on their investment property.  If you make this mistake, correct it immediately by filing to take the past
depreciation with your current tax return.  You can amend your tax
returns for the previous there years so that you can depreciate your properties on those returns (three years is the limit for amending past returns).

If you are not allowed to make the correction on an amended return, you can change your accounting method to claim the correct amount of depreciation.  To change your accounting method, you must file Form 3115, Application for Change in Accounting Method, to get the consent of the IRS.  In some instances, that consent is automatic. 
Important Note on Depreciation

If you don’t take the depreciation when you should, the IRS will
assume that you took it anyway.  If you ever sell your investment
property, you will have to pay tax on the recaptured depreciation
even if there’s nothing to recapture.  By not depreciating you will
lose the tax savings while you own the property and you will have
to pay taxes when you sell.

Section 179 Election

You cannot claim the section 179 deduction for property held to
product rental income.

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