Perhaps you may very well have heard that investing in real estate provides significant tax benefits. That is correct. The ability to apply depreciation laws on real estate assets, in particular, can significantly lower an investor’s taxable income. In many circumstances, it can even completely avoid income taxes.
Here’s an overview of real estate depreciation, how it works, and why it’s so beneficial to investors. We’ll also discuss how depreciation affects you when you sell a house and how to avoid having to pay the IRS on earnings from sold properties.
What Exactly Is Depreciation?
There are two primary methods for deducting company expenditures.
First, Some costs are deducted all at once in the year in which they occur. These are some examples:
- money spent on a consumable item,
- the expenses of running a business on a daily basis, and
- Purchases under a buck.
Second, Costs of assets with a one-year or greater service life can be reduced over a longer period.
Some assets, like rental properties, have IRS-mandated useful life lengths, which we’ll discuss later. Capital expenditures can be depreciated to lessen taxable income for a period of years. This is very beneficial to rental real estate companies.
How Does Depreciation Work For Rental Properties?
You can depreciate the cost of owning a property over time if you purchase it with the purpose of renting it.
Rental homes are not one-size-fits-all when it comes to service life. After ten years or so, some low-cost houses are worn out but some classic properties have been around for almost a century and are still in excellent rental condition.
Because of these, the IRS has set rules in terms of rental depreciation. Residential rental properties are preferred by the majority of real estate investors. According to the IRS, they can be treated as having a useful life of 27.5 years. In other words, you may calculate your yearly depreciation “expense” by dividing your cost basis in the property by 27.5. Commercial property has a standard depreciation period of 39 years.
Another crucial element to remember is that only the property’s value may be depreciated. It’s not the land on which it’s constructed. Land does not have a generation to come as buildings do. There will never be a day when land is “used up.”
There are different ways to determine the worth of a structure in relation to the land it sits on. You may, for example, have the property evaluated by a skilled specialist. To know the value of the land you may opt to use a tax assessment. This is another method used to know the worth of the property.
You can keep depreciating a rental property until you sell it or until you’ve depreciated your whole cost base.
In A Rental Property, What’s Your Cost Basis?
This is where things become a little more difficult. The price you paid the seller when you bought the property isn’t always your cost basis in the property. There are a few more items that might increase your cost base.
Any expenditures incurred in obtaining the property, for example, are added to your cost base. Legal or recording expenses paid to your local government, for example, might be added to your cost base.
You can also make any significant permanent or value-adding modifications to the property. Complex an extension to a home, installing a swimming pool in an apartment building, and upgrading the restrooms in a business facility are all examples.
Is It Possible To Depreciate Your Rental Property?
To depreciate rental property, you must fulfill the following requirements:
- It is expected that the property must be used for more than one year.
- The property must be yours. You can’t claim a depreciation deduction after renting a property then leasing it to someone else.
- You must be able to calculate the property’s operational life.
- You must create income from the property. When it comes to real estate, this usually means you rent it out to renters.
You should also intend to retain a rental property for longer than a year to depreciate it. You can’t depreciate the property if you plan to buy it, fix it up, then sell it a few months later.
Consult a skilled tax professional if you’re confused if you may claim depreciation on a property you only owned for a short period.
What Effect Does Depreciation Have On The Sale Of A Property?
When you own a property, depreciation may be one of your best friends. Depreciation, on the other hand, might be your biggest adversary when selling a rental property.
Here’s a condensed version. Your cost basis in the property decreases for capital gains purposes when you claim depreciation deductions annually on your tax return.
In other instances, the IRS assesses investment income based on a $175,000 investment if your expected cost in a property is $200,000 and you’ve taken a maximum of $25,000 in depreciation since you’ve purchased it. This implies that if you sell the house for $300,000 (after costs), the IRS will compute capital gains tax on a $125,000 profit rather than $100,000 profit. Depreciation recapture is the term for this notion.
Completing a 1031 exchange is one technique to avoid paying capital gains tax on a rental property transaction. This implies that you can avoid paying capital gains tax if you use the funds from the sale to purchase a comparable property.
We won’t go into too much detail about the mechanics of a 1031 exchange. Check out our 1031 exchange guide if you’re interested in finding out more.
The underlying concept is that you must acquire new real estate soon after the sale and that you must utilize almost all of the selling profits to do so. In other words, if the $300,000 sale paid off a $150,000 mortgage and delivered you $150,000 in cash, the capital structure of your new home should be similar.
Final Thoughts
If you invest in rental properties, depreciation may be a useful tool since it allows you to stretch out the cost of the property over decades, lowering your annual tax burden. Of course, if you depreciate something and subsequently sell it for more than its depreciated worth, you’ll incur depreciation recapture tax on the profit.
Because rental property tax regulations are complex and change frequently, working with an experienced tax professional while starting, maintaining, and selling your rental property business is always suggested. That way, you may be sure to get the best tax treatment possible and prevent any unpleasant surprises at tax time.