Summary:
Rental property depreciation is a potential tax credit you can generally claim if you own property that you rent out or is used for business purposes. Many landlords use the MACRS system to calculate their annual depreciation on rental property. This is where you subtract the cost of land from the property cost basis, then divide the depreciable value by the year
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In the challenge of trying to grow your independent property business, rental depreciation is a bit like an apple tree. The fruit appears year after year, just ripe for the picking. However, if you don’t use it, it will rot, wasted, on the ground.
Taxes are one place that it is easy to overlook opportunities. For example, according to the IRS over $1 billion in refunds went unclaimed for the tax year 2020, due to lack of proper tax filing.
That said, it’s essential not just to seize financial opportunities, but also to do it the right way. For example, like tenant screening, rental depreciation isn’t technically mandatory. However, it may be foolish to skip either when you’re trying to run a smooth, successful independent property business. That’s why so many independent landlords screen potential tenants through a quality services like SmartMove®.
Even so, with complicated tax codes, rules, qualifiers, and other details, it’s easy to get lost in the woods of rental property depreciation.
This article helps you understand how depreciation on rental property works, tips for calculating this deduction, the potential benefits of claiming rental property on your taxes, and other additional tips to consider for your annual filing.
Knowing what to expect can help you avoid costly mistakes ahead of time and potentially even avoid legal trouble down the line.
Here’s what it includes:
DISCLAIMER: Please be mindful that we do not intend this information to be complete or as tax advice (and you should not treat it as complete or tax advice). Before following any of the information, please consult your tax professional or legal counsel for guidance based on federal, state and/or local laws, and to assist with any questions to determine how this information may be conducted or impact you.
What is Rental Property Depreciation?
Buying a rental property like a building, house, or apartment is typically a long-term investment. Like many investments, you’re generally required to pay taxes on property every year. However, buildings typically deteriorate, need repairs, and lose their value as time goes on.
Because of this decrease, it doesn’t really make sense to pay taxes on the original property value every year. Thankfully, the IRS provides a tax deduction to offset this reality. According to the "IRS How to Depreciate Property", property depreciation is:
An annual income tax deduction that allows you to recover the cost or other basis of certain property over the time you use the property. It is an allowance for the wear and tear, deterioration, or obsolescence of the property
Property depreciation is one of many tax benefits for landlords. Additionally, the IRS considers “property” more than just a physical space where people live.
The same IRS guide linked above also explains you can also depreciate:
- Buildings
- Machinery
- Vehicles
- Equipment
- Furniture
- Note: land generally cannot be depreciated
So, if you have landscaping equipment, power tools, rent out furnished apartments, or have other similar expenses you use in your property business, you may be able to depreciate the value of these items, too.
Pro Tip:
Using your tax benefits isn’t the only way to save money as a landlord. Learn other ways to help maximize your rental income when managing property.
Is Rental Property Depreciation Required on Your Taxes?
According to mortgage lender site New Silver, depreciation is technically optional, but most property owners would be pretty foolish not to do it. Here are a few benefits and reasons why:
- It reduces your taxable rental income, which can help save you money
- It potentially lowers your annual tax bill
- It can help offset property expenses, making rental ownership more profitable over time
- If you sell the property for more than the depreciated value, the IRS may charge you a 25% recapture tax, whether you claimed depreciation.
The last one is especially important. Even if you don’t claim your depreciation, the IRS might treat your property sale as if you have been depreciating all along. To avoid being charged extra, you might as well claim what you’re allowed every year. After all, do you really want to pay taxes on a benefit you never received?
Pro Tip:
In addition to saving money at tax time, make sure to conduct quality tenant screening, otherwise you may be burdened with the high cost of an eviction
How to Tell if You Can Look into this Tax Benefit
According to the IRS, there are several criteria you can use to tell if your rental property is depreciable or not The most common terms include:
- You have to own the property
- The property must be used in a business or income-producing activity (like renting it out for money)
- It must have a determinable useful life
- It must be expected to last more than one year
So, for example, a condo you rent out may meet these requirements. However, Douglas Fir you buy to liven up your rental office around the holidays likely may not fit the criteria for depreciation.
Personal and Professional Mixed
UseOn top of that, there are circumstances when you might use equipment for both personal and business use––especially if you’re just getting started as an independent landlord and have just a few rental properties. Some general examples of split-use property might include:
- A lawn mower you use on your own yard and at your rental property
- A vehicle you drive most of the time, but occasionally use to conduct rental inspections
- A home office or computer you use mostly for property management, but occasionally use for personal or other business
The IRS explains that if you use property for both personal and business use, you may only deduct the portion you use for business use. This may also be the case if you rent out a room in your house.
Pro Tip:
Speaking of mowing the lawn, updating landscaping can be one of the best ways to improve your rental property for less than 1,000. It may even be enough of an upgrade to charge more for rent.
Tips on Calculating Rental Property Depreciation
The IRS provides instructions for different depreciation methods. The one you use typically depends on when you started renting out the property.
Here are the main IRS recommended methods for calculating depreciation, based on when your rental property was placed “in service”:
- Placed in service after 1986: Modified Accelerated Cost Recovery System
- Placed in service 1980-1987: Accelerated Cost Recovery System (ACRS)
- Placed in service before 1981: Straight Line or Declining Balance method
Below, you’ll find a description and example of calculating depreciation according to the Modified Accelerated Cost Recovery System. For information about ACRS, Straight Line, or Declining Balance methods, consult the IRS website.
Modified Accelerated Cost Recovery System (MACRS)
Not surprisingly, the MACRS guidelines provided by the IRS can be complicated, confusing, and can vary a lot depending on your personal circumstances. Below, you’ll find a simplified description to help you understand the basics. However, if you have specific questions for your personal circumstance, please ensure to contact a qualified tax professional.
In general and at a high level, to calculate depreciation under MACRS, here’s what you need to do:
- Determine the Property Basis: This is usually the purchase price, it sometimes includes costs like sales tax, some types of insurance, legal fees, surveys, transfer and title fees.
- Separate the Land Value: According to the IRS, you cannot depreciate the cost of land, because, unlike buildings, land does not wear out or become obsolete. When calculating depreciation, you generally need to subtract its value.
- Apply the MACRS Recovery Period: Generally, residential rental property has a recovery period of 27.5 years.
- Calculate the Annual Depreciation: To calculate rental property depreciation, you divide the depreciable value by the recovery period.
MACRS Rental Property Depreciation Example
Let’s say you bought an investment property and you rent it out. The property cost $280,000. To calculate your rental property depreciation according to MACRS, you do the following:
- Find the depreciable value. For this, you subtract the Land Value from the cost basis. For example, Let’s say the land is worth $50,000.
- So, you subtract $280,000 (cost basis) - $50,000 (land value) = $230,000.
- The depreciable value is $230,000
- Calculate your annual depreciation deduction. Here, you divide the depreciable value over the MACRS recovery period, which is generally 27.5 years.
- So, you divide: $230,000 (depreciable value) ÷ 27.5 (deduction years allowed by the IRS) = $8,364
- Your annual depreciation deduction is $8,364/year
In short, under MACRS, you’d deduct about $8,364 annually for 27.5 years until the property’s depreciable value is fully recovered. As you can see, this could really make a difference on your tax burden over time.
Again, this is a very basic and simplified example calculation. You may also need to take into account differences if your rental unit went into service mid-month, if it falls under special tax rules, if it has been in service since the ‘80s, and more.
Timing: When to Start and End Depreciation
The IRS provides several rules that govern when you’re allowed to start depreciation on a rental property and when you’re required to stop taking the deduction. You can find the general rules below.
When You Can Start Claiming Rental Property on Your Taxes
According to IRS Publication 946, you can start depreciating property when it is “placed in service.” Essentially, you can start depreciating the property when it becomes available as a rental property.
Example of when rental property is “placed into service”: If you buy a house in May, spend two months upgrading it, put out an enticing rental ad in July, and get a tenant in August, you can start depreciating the property from July. This is because, though you bought it in May, it wasn’t “placed into service” until July.
Then, while you’re waiting for rental applicants to respond to your ad, make sure you have a quality rental application that includes a notice that you will run a rental background check.
From the get go, you can learn about potential tenants:
- Financial history: Get a tenant credit check, including ResidentScore®, a proprietary score which helps predict potential evictions risk 15% better than a general credit score alone.
- Criminal history: A criminal records check scours hundreds of millions of crime records from state and local agencies, while a past eviction check helps you learn more about the applicant’s rental history.
Like rental property depreciation, background checks help you protect your investment.
When You Stop Depreciating Your Rental Property
The same IRS publication linked above, also has guidance for when to stop rental property depreciation. In general, you should cease depreciating property in the following circumstances:
- When you’ve fully recovered your cost or cost basis. Essentially, this means that all the deductions you’ve taken add up to the cost of the investment you made in the property (i.e. you made back what you spent).
- The property is taken out of service. This happens when you permanently remove the property from business use (i.e. stop renting it out). For example, if you sell it, convert it to personal use, abandon it, or it is destroyed.
- The depreciation window ends. There is a limit to the number of years you can depreciate a property. For rental properties, this is typically 27.5 years.
As with any rental-related business, make sure to keep your important landlord documents organized and secure.
Help Get the Most Out of Your Property Business with SmartMove
As an independent landlord, you’re focused on sustainable growth. And, often that means investing time and money upfront for a better return down the line.
For rental property depreciation, that could mean calculating and taking the deduction, by hiring a tax professional to help figure it out. For choosing tenants, that means conducting fast, affordable tenant screening through SmartMove.
All of your tax savings won’t mean much if you have to spend it picking up after ill-fitting tenants who trash the place. A criminal background check searches through millions of criminal records, looking for a potential match to your applicant.
Meanwhile, eviction checks can help you better understand a potential tenant’s rental history and an identity check helps confirm they’re really who they say they are. Wouldn’t knowing more about your potential tenant’s history help give you better peace of mind?
As you work to meet your tax requirements and financial obligations, are your rental applicants doing the same? Take a deep dive into a potential tenant’s track record with a credit check. Then, use Income Insights to help identify they really make the income they claim on the application.
Even better, included in all screening packages, a ResidentScore® is a proprietary calculation based on thousands of real-world rental outcomes. Specifically designed for landlords and tenants, ResidentScore helps predict eviction risk 15% better than a general credit score alone.
Online reports are available after your rental applicant enters their information. All reports are backed by TransUnion, a major credit agency with four decades of data expertise, so you can feel more confident about your leasing decision.
Don’t let one bad apple spoil the bunch. Help weed out potential ill-fitting tenants with fast, reputable tenant screening through SmartMove.
SmartMove
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Know your applicant.
Additional Disclosure:
The information posted to this blog was accurate at the time it was initially published. We do not continue to guarantee the accuracy or completeness of the information provided. The information contained in the TransUnion Rental Screening Services, Inc. blog is provided for educational purposes only and does not constitute legal or financial advice. You should consult your own attorney or financial adviser regarding your particular situation. For complete details of any product mentioned, visit www.transunion.com. This site is governed by the TransUnion Rental Screening Privacy Policy Privacy Notice located at TransUnion Rental Screening Solutions, Inc. Privacy Notice | TransUnion.
