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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 it’s calculated and applied differently. Also, failing to take a deduction for depreciation can lead to some problems later on. This is why it’s important for Boonville rental property owners to fully comprehend what depreciation is, how it affects your finances, 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. To state it differently, owners shouldn’t have a one-time deduction of the purchase cost, but instead, they should be deducting a portion of their purchase and improvement costs (not operating or maintenance costs) each year for several years. This could largely reduce the value of taxable rental income that you report on your tax return, making depreciation worth the time it takes to calculate.

The owner of the property may begin taking depreciation deductions as soon as the rental property is placed in service, or in short: ready to receive tenants. That’s favorable news especially if you’re a property owner who has to deal with a vacancy right after the purchase or during renovations. The period of time you continue to use depreciation depends on a couple of things— how long you own and use the property as a rental, and which depreciation method you use.

There are different depreciation methods. Each one can 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). Usually, MACRS is used for any residential rental property placed in service after 1986. If you use this method then the cost to purchase and improve 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 find out how much your depreciation should be each year, there are a few things you’ll need. 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. Usually, you can use property tax values to calculate what amount of the purchase price should be designated for the house, or your accountant might elect to use a standard percentage.

Once you’ve figured out the amount just for the rental house, you’ll need to take a step further and figure out your adjusted basis. You can increase the basis in a rental property 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. It can 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. Using your adjusted basis, you can begin to 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 easy or simple. You need to keep updated because rental property tax laws can be complex and change quite a bit over time. Because of this, it’s best to work with a qualified tax accountant to ensure that depreciation is being calculated and applied correctly.

When you hire Real Property Management Results, we can link you with accounting professionals who can help you answer all 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. Please contact us online or call us at 812-461-1676 to learn more about how our Boonville property management services can serve you.

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