Definition
Depreciation for rental property refers to the reduction in value of an asset over its useful lifespan due to wear and tear, age, or obsolescence. In finance, this is considered a non-cash expense that reduces the owner’s taxable income. The Internal Revenue Service (IRS) provides specific guidelines on how to calculate this depreciation for tax purposes.
Key Takeaways
- Depreciation for rental property is an income tax deduction that allows a taxpayer to recover the costs or other basis of certain property. It is an annual allowance for the wear and tear, deterioration, or obsolescence of the property.
- This process involves a series of annual deductions over the useful life of the property. The IRS has defined a specific depreciation period for the rental properties, usually 27.5 years for residential property and 39 years for commercial property.
- The amount of depreciation that can be claimed each year is determined by the value of the property, the recovery period for the property, and the depreciation method used. The cost basis of the property is divided over the lifespan to determine the annual depreciation expense.
Importance
Depreciation for rental property is an essential financial concept because it allows property owners to allocate the cost of the property over its lifetime.
Essentially, it’s a tax deduction that rental property owners can take each year until they recover the amount they spent on the property.
This is important because it can significantly lower the annual tax liability, enhancing the cash flow and potential return on the investment.
Understanding depreciation also helps owners to strategically manage their property portfolio, make informed decisions about buying or selling properties, and adequately plan for future expenses associated with property deterioration over time.
Explanation
Depreciation for rental property serves as a vital tool for property owners to manage and lessen their tax liability. This is an allowance that the Internal Revenue Service (IRS) permits for the decline in value of a physical asset over time, caused primarily by wear and tear.
Depreciation for rental properties allows property owners to recover the cost associated with buying and improving a property through annual tax deductions, ultimately, reducing taxable rental income and taxes owed. Depreciation begins when a landlord places a rental property in service for income production and ends when the owner has fully recovered the property’s cost or other basis or when the owner retires it from service – whichever happens first.
Any property, be it a residential building, a commercial building, or even a warehouse, would inevitably deteriorate over time due to natural causes, despite regular maintenance. Thus, landlords can employ depreciation to account for this inevitable reduction or loss in value, making it a critical element in the calculation and planning of long-term financial strategies for property investment.
Examples of Depreciation for Rental Property
Residential Rental Property: If an individual purchases a residential property such as a house or a multistory building with the intent to rent it out, that property can depreciate over time due to wear and tear. For example, if Mr. Smith bought a residential house for $250,000 and choose to rent it out, he would be able to depreciate the value of the house (excluding land value) over the IRS prescribed life of
5 years, in his annual tax filings.
Commercial Real Estate: Suppose a business purchases a commercial building to rent out office space to other businesses. Despite improvements and maintenance efforts, inherent wear and tear caused by the various tenants and the passage of time causes the building’s value to depreciate. This depreciation is considered an operating expense and can be deducted from the gross rental income, which could have sizable tax benefits for the property owner.
Machinery/Equipment for Rental Business: Consider a company that rents construction machinery like backhoes, forklifts, etc. Over a period of time, due to continuous usage and the nature of the job they are utilized for, these machines depreciate in their original value. This depreciation is tax deductible and helps the business decrease its overall taxable income.
FAQs about Depreciation for Rental Property
1. What is depreciation in terms of rental property?
Depreciation refers to the gradual loss in the value of the rental property due to factors like general wear and tear, age, or deterioration over time. This is considered an operational expense and can be deducted from the taxable income accrued from the rental property.
2. How is depreciation for rental property calculated?
Depreciation is usually calculated using a straight-line method for rental property. This involves dividing the property’s purchase price by its useful life span, which is typically 27.5 years for residential real estate according to the IRS.
3. Can I claim depreciation for all parts of my rental property?
No, land is not depreciable. Only the buildings or the parts of the property considered improvements can be depreciated.
4. When can I start depreciating my rental property?
You can start depreciating your rental property when it is ready and available for rent, not necessarily when it is rented out.
5. Is depreciation for rental property optional?
No, depreciation for rental property is not optional. If you use a property for income production, you are required to depreciate it.
Related Entrepreneurship Terms
- Asset Lifespan: The estimated period a rental property or item within it will maintain its value and usefulness.
- Cost Basis: The original value or purchase price of the rental property which is used to determine the depreciation.
- Capital Expenditures: Also known as CapEx, these refer to the serious improvements and major repairs of the property that extend the value or usability beyond its current condition.
- Section 179: A U.S. tax rule allowing business owners to expense specific types of property, which, unlike depreciation, could provide an immediate income reduction.
- Salvage Value: The estimated resale value of the rental property after the depreciation period has been completed.
Sources for More Information
- IRS (Internal Revenue Service): The official website of the U.S. Internal Revenue Service, providing information on tax laws, regulations, and guidelines – including details about depreciation for rental property.
- Investopedia: A comprehensive financial website that explains finance and investing terms in easy-to-understand language. They have various articles on depreciation, rental property, and real estate investing.
- Nerdwallet: A personal finance website that provides information, insights, and tools for understanding and managing personal finances. It includes content related to real estate investment and depreciation.
- BiggerPockets: A real estate investing social network, information hub and marketplace. They frequently post articles and host discussions on topics like property depreciation.
