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 it’s calculated and applied differently. Also, failing to take a deduction for depreciation may result in unwanted consequences later on. Because of the potential repercussions, it’s important for Brandywine 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 stated that rental property owners should divide the amount of those kinds of deductions over the useful life of the property. To put it another way, owners would not go with one large deduction on the date of purchase but will 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 may begin taking depreciation deductions as soon as the rental property is placed in service, or in short: ready to receive tenants. That is great news for property owners who have to deal with a vacancy right after 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 that would result in different figures. You can use whichever method 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). Normally, MACRS is used for any residential rental property placed in service after 1986. Using this method, the cost to buy 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 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 a bit complicated 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.
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. The basis can decrease, too, 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, 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 hire Real Property Management Gold, we can link you with accounting professionals who can help you answer all your depreciation questions and more. Teaming up with our experts can help property owners make sure that there are no unpleasant surprises when tax time comes. Please contact us online or call us at 301-392-2172 to learn more about how our Brandywine property management services can serve you.
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