There are certain financial benefits of investing in rental properties. A few of them take effect when tax time comes and investors get to deduct operating expenses, property taxes, and so on. And on top of that, there is another thing they can deduct— depreciation. This key tax deduction works differently from the others because of how it’s calculated and applied. Also, failing to take a deduction for depreciation can make things problematic for you down the road. Because of the potential repercussions, it’s important for Mountain House rental property owners to fully understand depreciation, how to use it properly for your benefit, 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 suggests that rental owners break the amount and spread those kinds of deductions over 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 could dramatically reduce the amount you report as your taxable rental income. The huge effect this has on your tax return makes depreciation well worth the time it takes to calculate.
The owner of the property can begin taking depreciation deductions as soon as the rental property is placed in service, or another way to say it: when it’s ready to be rented out. That is welcome news for property owners who have to go through a vacancy, either right after buying the home or during renovations. The duration you continue to deduct depreciation depends on how long you own and use the property as a rental, and which depreciation method you use.
There are different depreciation methods you can use 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). Generally, MACRS is used for any residential rental property placed in service after 1986. By using this method, the expense of buying and improving 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 compute how much your depreciation should be year-on-year, you’ll need to figure out 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. This number is quite complicated because 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. For the most part, you can use property tax values to help figure out how much of the purchase price should be designated for the house, or your accountant might elect to use a standard percentage.
As soon as you have the amount for the rental house alone, you’ll need to move a step more and figure out your adjusted basis. A basis in a rental property can be revised 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, it’s not very simple or straightforward since rental property tax laws can be complex and change quite a bit every so often. This is why 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 One, we can get you in touch with accounting professionals who can address your depreciation questions and more. Our experts can help property owners make sure that you are ready and that there are no unpleasant surprises at tax time. To learn more about what our Mountain House property management services can do for you, please contact us online or give us a ring at 925-495-4953.
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