What Is Depreciation?
This all sounds like a bummer, but there’s an upside! Depreciation allows for a tax benefit for that degradation. Any fixed asset or capital good with a finite usable lifespan can depreciate, including homes, automobiles, or investments. In some cases, intangible assets such as patents and copyrights can also depreciate.
Depreciation means real estate investors can write off the cost of a property or improvements over time, which can have years-long income tax benefits. Through depreciation write-offs, you can reduce your net income—in turn reducing your taxes. For tax purposes, the more rental properties the merrier… to an extent. Make sure to pay attention to how depreciation can hurt your portfolio, too.
What Is the Most Common Depreciation Method?
In order to be able to depreciate an asset following the straight line method, the following conditions must be met:
- You must own the property outright
- The useful life of the asset must be more than one year
- It must be used for business or income-producing purposes.
How Is Real Estate Depreciated?
- Automobiles: 5 years
- Office furniture: 7 years
- Multi-unit housing: 27.5 years
- Office buildings and commercial property structures: 39 years.
What can’t I depreciate?
- You cannot depreciate land, so you (or your accountant) will need to establish what the structure is worth versus what the land is worth and only depreciate off the structure.
- You can no longer depreciate a property if you move into it yourself.
- You can no longer depreciate a property that’s been fully depreciated (meaning, you’ve depreciated it past 27.5 years).
When Can I Start Depreciating My Property?
How Much Is Depreciation?
If you purchase a property mid-year, for the first year, you have to depreciate via Schedule E on your tax return—which means lower depreciation as you get further into the year.
What is Depreciation Recapture?
Real estate assets are known as Section 1250 assets by the IRS. They get special tax treatment on asset gains upon sale. If a real estate investor sells a property for a profit (any amount over their adjusted cost basis), this profit is taxed at a rate of 25%, up to the total aggregate amount of depreciation claimed over the years of ownership. Any gains in excess of this aggregate depreciation taken by the investor is taxed at the prevailing long-term capital gains rate (a preferred, lower tax rate).
As an example, consider a property investor who buys a rental property fot $280,000. They claim depreciation of 3.36% per year as a deduction against ordinary income. If they hold the property for 10 years, the total accumulated depreciation would be:
($280,000 * .0336 * 10) = $94,080
If the property is sold for a profit of $100,000, the full $94,080 of depreciation is recaptured and taxed at 25%. The remaining profit of $5,920 is taxed at the long-term capital gains rate.
But any tangible, fixed asset with a usable life will depreciate over time, regardless of how the accounting is handled. Some larger companies only depreciate when the cost of the asset is more than $20,000; small business owners may depreciate smaller fixed assets, with an original cost of $10,000 or less.
If an asset has any value left after all depreciation has been taken—i.e. the end of its estimated “usable life” has been reached—that amount is known as the salvage value. No more tax benefits can be accrued after this point.