Key Takeaways

1. Depreciation is a tax-saving tool – Landlords can deduct property wear and tear over time.
2. Only income-generating properties qualify – Personal residences and land aren’t eligible.
3. Accurate calculations matter – Use cost basis minus land value and spread over 27.5 years.
4. Beware of recapture tax – Use a 1031 Exchange to defer taxes when selling.

One of the key responsibilities landlords have is filing taxes when the season comes around. The Internal Revenue Service (IRS) allows landlords to make certain deductions, which can help minimize rental expenses for optimal ROI.

Now, one of the qualifying deductions per the IRS is depreciation. This tax deduction allows investment owners to account for their property’s wear and tear. If you do it properly, you can save thousands of dollars in tax liability every year.

But to enjoy maximum benefits, you’ll need to carefully pay attention to certain rules and requirements. In today’s blog, B&R Property Management will share everything you need to know about depreciation and property value.

What is Rental Property Depreciation? 

Depreciation refers to the expected gradual decline in the value of your rental apartment over time due to wear and tear. Other contributing factors include age and obsolescence.

The IRS allows investment property owners to recover some of the property’s cost as a tax deduction over time. You cannot, however, deduct the entire amount in a lump sum. Rather, you must spread the deduction across your rental apartment’s useful life.

There have been certain changes to the U.S. tax code since depreciation became a taxable deduction. The system in use currently is based on the changes that occurred in 1986 when depreciation was standardized. 

What Property Qualifies for Depreciation per the IRS?

The qualification for depreciation doesn’t apply to all properties. The IRS requires that a property meet the following criteria to be eligible.

• You must outrightly own the rental property even if it is subject to a mortgage. Therefore, people like property managers and renters are automatically disqualified per the IRS.
• You must be using the property to generate an income. As such, all rental investments qualify for deduction. On the other hand, personal property like an own home isn’t eligible.
• The property you’re seeking to depreciate must have at least one permanent structure.
• Land doesn’t qualify for depreciation because, unlike structures, it doesn’t undergo wear and tear.

How can a Landlord Calculate Property Depreciation?

To calculate depreciation, you’ll first need to determine the cost basis of your apartment. Cost basis refers to the property’s purchase price plus the closing costs, fees, and other capitalized costs. You’ll then need to subtract the cost of the land since it doesn’t qualify for depreciation.

Now, suppose the purchase price of a rental property is $250,000 and closing costs add up to $5,000. Let’s also suppose that you have made some capital improvements on the property amounting to $10,000.

The total initial cost would be: $250,000+5,000+$10,000=$265,000. Remember that land is, however, a non-depreciable asset.

You’ll, therefore, need to subtract that amount from the total initial cost. If, say, land is valued at $70,000, then the depreciable basis would be: $265,000-$70,000=$195,000.

After determining the depreciable basis, the next step is to determine the annual depreciation.

Generally, for residential property, the depreciation period is 27.5 years. Thus, to calculate annual depreciation, divide the depreciation basis by the depreciable period. $195,000/27.5=$7,091. This would be about $591 a month.

Next, calculate the mid-month convention. This will mean that the IRS will treat your property as being placed in service in the middle of that month, regardless of when the lease date is during that month.

For the sake of the following calculation, let’s assume that the property is placed in service in the middle of April. The depreciation for the first year would be $591X8.5=$5,023.50 (Dec 31 to April 15 is about 8.5 months).

How to Avoid Depreciation Recapture Tax on Rental Property?

As already aforementioned, investment property owners can qualify for a depreciation deduction. That said, upon selling your rental investment, the IRS will try to recapture or collect the amount through recapture tax.

Recapture tax is simply the difference between the property’s depreciated value and the sale value. Generally, a rental property’s depreciation recapture tax is capped at 25 percent of the original depreciation amount.

After the IRS deducts the recapture tax, they then apply capital gains tax on the remainder of your profit.

Fortunately, you may be able to avoid recapture tax the same way you would capital gains tax. Which would require you to defer both the recapture tax and capital gains tax through a 1031 Exchange.

For you to qualify for the deferment, however, there are certain qualifications such as:

• The property must be like-kind. The properties being exchanged must be real property held for either investment, business, or trade.
• You must adhere to certain timeframes. That is, the 45-Day identification period and the 180-Day Exchange period.
• There must be a qualified intermediary. The goal of the intermediary is to hold the funds from the sale and use them towards the purchase of the replacement property on your behalf.

What Mistakes Should You Avoid when it comes to Depreciation Deductions?

To qualify for depreciation deduction during the next tax season, the following are the common mistakes and pitfalls to avoid:

• Not separating the value of the land from the rental building. Please note that land doesn’t qualify for depreciation.
• Neglecting to start depreciation from the date you start renting out your apartment rather than when you buy it.
• Failing to account for capital improvements made to the property separately from repairs.

Conclusion

As a landlord, taking advantage of property depreciation can help maximize your tax deductions. However, knowing the intricacies of the process is key to ensuring strict compliance with the IRS rules and regulations.

If you have a question or need expert help in managing your Las Vegas rental property, look no further than B&R Property Management. We’re an experienced, full-service apartment management consultant company; get in touch to learn more!