How to Calculate Depreciation on Rental Property

Running a rental property business comes with a number of tax obligations. However, did you know that there are also ways for you to lower your tax burden by accounting for your rental property’s depreciation? This strategy allows you to deduct a portion of the depreciation attributable to your property from your taxable income each year. Sounds interesting? Continue reading to learn more about how to calculate depreciation on rental property.

Key Takeaways

• Rental property depreciation is a valuable tax strategy that allows landlords to deduct a portion of their property’s value each year.
• To qualify for depreciation, the property must meet IRS requirements, including being income-producing, owned by the taxpayer, and expected to last longer than one year.
• Calculating rental property depreciation involves determining the property’s cost basis, subtracting the land value, dividing the depreciable basis by 27.5 years, and accounting for the IRS mid-month convention.

How Does Rental Property Depreciation Work?

Through our experience in Atlanta property management, we know that rental property depreciation is a tax benefit that allows property owners to deduct a portion of the property’s value over time for tax purposes. Property owners can recover the depreciable portion of the property’s cost over its assigned useful life through annual tax deductions.

Rental property depreciation accounts for the wear and tear, age, and obsolescence the property experiences over the years that it is used. The general idea is that for tax purposes, the IRS allows owners to recover the property’s depreciable basis over time (excluding land value). But, instead of receiving the full cost of depreciation in just one year, the IRS requires you to spread this over the span of the property’s useful life. Currently, the IRS assigns residential rental properties a recovery period (useful life) of 27.5 years.

However, in order to leverage this tax benefit, the IRS has also established several depreciation eligibility requirements that you need to meet:

• You legally own the property, regardless of whether you still have a mortgage on it.
• The property is used as an income-producing asset, such as long-term residential rentals.
• The property has a determinable useful life, typically a permanent structure that can wear out, decay, or lose its value over time.
• The property is a long-term asset that is expected to last longer than one year.

For rental property owners, one of the biggest advantages of rental property depreciation is that it reduces their taxable rental income. This, in turn, allows you to retain more of your profits and improve your annual cash flow. For the long term, rental property depreciation is instrumental in lowering your overall tax liability, especially when combined with other tax benefits, such as deductions on mortgage interest, capital improvements, management expenses, and other eligible deductions.

How to Calculate Depreciation on Rental Property

Taking all of these into consideration, let’s jump right into the steps on how to calculate depreciation on rental property. At first glance, this may appear complex. However, you can start by learning the basics of the depreciation calculation.

First, let’s go over the depreciation methods. Generally, the IRS uses the Modified Accelerated Cost Recovery System (MACRS) to calculate the depreciation deductions of residential rental properties that are put into service after 1986. Now, the MACRS also has two variations – the general depreciation system (GDS) and the alternative depreciation system (ADS).

Typically, the GDS is the standard method, and it establishes the following:

• A 27.5-year recovery period for residential rental properties.
• Straight-line depreciation methods mean that deductions are applied in the same amount every year.
• The mid-month convention assumes that properties are placed into service in the middle of the month (the 15^th), regardless of the exact start date.

Now, let’s move on to how to calculate depreciation on rental property, following the above-mentioned guidelines.

Determine Cost Basis

The first step is to determine your property’s cost basis, which is the total amount you have invested in the acquisition of the property. Generally, this includes the purchase price of the property, closing costs, legal fees, title insurance, transfer taxes, and the like. On the other hand, the cost basis excludes some expenses, such as the loan origination fees, mortgage interest, property insurance premiums, and escrow deposits. So, let’s say that you bought a property for a purchase price of $325,000, and additional acquisition costs totaled $5,000. This brings your cost basis to $330,000.

Deduct Land Value

The next step is to deduct land value from your cost basis. This is simply because the IRS determines that land itself does not depreciate in value and, therefore, must be excluded from the calculation. To determine your land’s value, you can use county tax assessments, real estate appraisal reports, or even your purchase allocation documents. Now, if your cost basis is $330,000 and your land is valued at $70,000, this brings your depreciable basis to $260,000.

Calculate Annual Depreciation Value

In order to come up with your annual depreciation value, you need to apply the assigned IRS recovery period, which is 27.5 years. Using your depreciable basis, your annual rental depreciation is calculated as:

Annual Depreciation = Depreciable basis/recovery period

Annual Depreciation  = $260,000 / 27.5 = $9454.54

This means that your estimated annual depreciation for your rental property is roughly $9,455 per year, or around $788 per month.

Account for the Mid-Month Convention

The mid-month convention is an assumption where the IRS places the depreciation start date for residential rental properties in the middle of the month, regardless of the actual start date. So, even if you place your property in service on the 1^st or the 20^th day of the month, under the IRS mid-month convention, residential rental property is treated as being placed in service in the middle of the month.

Now, what happens with the mid-month convention is that it affects your first-year and last-year depreciation values. For example, if you have your property placed in service in May, then you’ll only have 7.5 months accounted for your first year of depreciation. Following our earlier example, then:

First year of depreciation = $788 x 7.5 = $5,910

After this, your annual depreciation will return to the full 12-month period of depreciation, which is $9,455, for subsequent full years. However, on your final year of rental property depreciation, you can only account for the 10.5 months remaining on your recovery period. This will bring your final year of depreciation to:

Final year of depreciation = $788 x 10.5 = $8,274

The mid-month convention simplifies how the full 27.5 years of the recovery period of the depreciated property are deducted accordingly. It also simply means that you’ll have lower depreciation deductions on your first and final year of depreciation. Do take note that actual depreciation calculations may vary slightly based on IRS MACRS tables and rounding conventions.

FAQs

Can you take bonus depreciation on a rental property?

Bonus depreciation is a different tax benefit that applies to eligible assets that have a useful life or recovery period of no more than 20 years. So, while the structure or building of the rental property does not qualify for bonus depreciation, you might be able to use it on certain assets, such as appliances, fixtures, land improvements, etc. Keep in mind that bonus depreciation rules can change based on federal tax law, so regularly review tax guidelines or consult a qualified tax professional as needed. Currently, bonus depreciation percentages are being phased down under federal tax law and may continue changing in future tax years.

Can you use accelerated depreciation on a rental property?

Yes, it’s also possible to use accelerated depreciation on your rental property. However, this doesn’t apply to the building itself. Instead, the strategy of deducting a larger portion of the property’s value in the early years of ownership works with individual assets with shorter lifespans than the building itself, including appliances, electrical systems, landscaping, lighting, and even carpeting. The accelerated depreciation approach is most often utilized along with a cost segregation study to identify eligible components of the rental property.

How does depreciation recapture work on rental property?

The depreciation recapture is one of the drawbacks of the depreciation strategy. When a rental property is sold, some or all previously claimed depreciation deductions may be subject to depreciation recapture taxes, which can be taxed at a maximum federal rate of 25% under Section 1250 rules.

How Bay Property Management Group Can Help

For rental property owners, depreciation is one of the most commonly used strategies to lower yearly tax liability. But more than that, depreciation also helps in improving your cash flow, which allows for portfolio growth and reinvestment opportunities. That is why it’s important to know how to calculate depreciation on rental property.

Looking for professional support in managing your Atlanta rental property? Bay Property Management Group can help. Contact us today to learn more.