BiggerPockets

The Truth About Depreciation

As a rental property owner, there are no tax benefits to making principal payments for your property - you only get to right off the interest. As a result, many people get taxed on their income from rental properties, and if you are like me, you don't want to get taxed on the additional revenue that your rent brings you. One good thing about owning rental property however is that you can claim a tax loss even though you are making a profit. This is possible through depreciation.

By maximizing depreciation deductions, you minimize taxable liability and save money on taxes. Since you cannot immediately write-off the purchase cost of investment property, you must deduct the acquisition cost over the life of the property using depreciation.

Most rental owners are able to turn profits after collecting rent and paying rental expenses, so depreciation deductions can be used to turn their profits into tax losses. That's why rental property is considered such a good tax shelter - because you can report a loss even though you are making a profit.

For example, you collect $12k rent for the year and paid $8k in rental expenses like mortgage interest and property tax. If you took no depreciation deduction, you would have to claim $4k in rental income on top of your regular income... but after a $6k depreciation deduction (typical for property worth $165k), you will claim a $2k loss while still making a $4k profit. So the depreciation allows you to avoid taxes on the additional income ($4K) that you made, and it also allows you to take a loss ($2k) against your other income and pay less taxes against what you would have owed without the rental property.

I hope this explanation was easy to understand. Depreciation is a simple concept but can easily turn into a difficult topic. For example, depreciation may be recaptured at a rate of 25%. Also, there are passive activity rules that limit the amount of loss you can claim, and then again, there are exceptions to that rule that allow you to take unlimited losses.

Be sure to consult with a tax advisor to consider your specific circumstances.

Comments

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  Jerome Cleland — about 3 years ago

  Niman, You are spot on about depreciation. The one thing that you didn’t mention is that commercial property owners can put their depreciation on steroids by doing what is called a cost segregation study. Rather spreading depreciation out over 39 years you can have a study performed that allows you to break a building down into its individual components, placing them into their own life cycles. The net impact is an immediate jump in depreciation, meaning greater tax write-offs and a freeing up of cash-flow. When you think about it, it is the common sense approach to depreciating, and the IRS realizes this as well. Why write off your carpet over 39 years when you are going to replace it after five? Take the write-offs (cash) while you got the objects. The one caveat is that the IRS is becoming more and more stringent on looking at who actually performs the study. It is key to get an engineer based study performed and not leave it up to someone who does not know the intricacies of engineering. You can risk doing a non-engineering report (you can also perform your own dentistry) but why take the risks when the costs are nominal and the benefits far outweigh the costs. The American Institute of Certified Public accounts published an article on the subject. http://www.firstcostseg.com/xSites/Agents/costsegpartners/Content/UploadedFiles/AICPA-%20Money%20Doesnt%20grow%20on%20trees.pdf

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  Niman S. — about 3 years ago

  Hi Jerome, I totally agree. In fact, accelerated depreciation is not specific to commercial property. Our software (DepreciateEm.com) does it for residential rentals. I wrote an article on it, and it was published in Invest Magazine. Check it out: http://www.mydigitalpublication.com/publication/?i=8286&p=67