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Depreciation De-Mystified: An Introduction to Rental Property Depreciation

Dollar Bill Origami of a HouseThere are many financial benefits of investing in rental properties. Some come during tax time when investors get to deduct operating expenses, property taxes, and so on. But on top of all these benefits, investors also get to deduct depreciation. This key tax deduction works differently from the others because of the unique way it’s calculated and applied. Also, failing to take a deduction for depreciation can lead to problems down the road. On account of this, it’s vital that Palm Harbor rental property owners know what depreciation is, how to use to your advantage, and why you should be deducting it on your taxes every year.

In terms of buying and improving rental properties, depreciation is the process used to deduct any associated costs. Rather than take one large deduction in the year the property was purchased or improved, the IRS has prescribed that rental property owners should split those kinds of deductions across the useful life of the property. So basically, owners will not have one huge deduction but would be deducting a portion of their purchase and improvement costs (not operating or maintenance costs) each year for several years. This can substantially affect the amount of your taxable rental income that you place on your tax return, making depreciation worth the time it takes to calculate.

Property owners may begin taking depreciation deductions as soon as the rental property is placed in service, or in essence: ready to be used as a rental. That’s favorable news especially if you’re a property owner who has to deal with a vacancy right off the purchase or during renovations. The number of years you’d spread the depreciation cost depends on two things. First, how long you own and use the property as a rental, and second, which depreciation method you use.

There are different depreciation methods that use different approaches to determining the annual expense. You may use any of them to determine the amount you can deduct each year. But the most common one for residential rental properties is the Modified Accelerated Cost Recovery System (MACRS). Most often, MACRS is used for any residential rental property placed in service after 1986. Through this method, the cost to buy and upgrade a rental property is spread out over 27.5 years, which is what the IRS considers to be the “useful life” of a rental house.

To calculate how much depreciation you can deduct each year, you’ll need to know your basis in the property or the amount you paid for it. You may also be able to include some of your settlement fees, legal fees, title insurance, and other costs paid at the settlement. What makes this number difficult to get is that you’ll need to separate the cost of the land from the building since only the rental house itself – and not the land it is built on – can be depreciated. Generally speaking, you can use property tax values to get the amount of the purchase price that would be allotted for the house, or your accountant might elect to use a standard percentage.

When you’ve computed the amount just for the rental house, you’ll need to do one more thing, and that’s to figure out your adjusted basis. A basis in a rental property can be raised to account for things like major improvements or additions, money spent restoring extensive damage, or the cost of connecting the property to local utility service providers. The basis may also decrease in the event of insurance payments you received to cover theft or damage and any casualty losses you took a deduction for already that were not covered by your insurance. From the adjusted basis, you can now calculate the amount of depreciation you can deduct on your income tax return.

Depreciation of a rental property is a valuable tool for investors looking to reduce their annual tax obligation. However, rental property tax laws can be complex and change quite a bit over the course of a few years. Since this is the case, it’s best to work with a qualified tax accountant to ensure that depreciation is being calculated and applied correctly.

When you avail of the services of Real Property Management TradeWinds, we can get you in touch with accounting professionals who can address your depreciation questions and more. Coming together with our experts can help property owners make sure that there are no unpleasant surprises at tax time. Feel free to contact us online or by phone at 727-400-4722. We’ll be glad to answer any questions you may have about our Palm Harbor property management services.

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