Buildings depreciate, but land doesn’t wear out
Depreciation is based on the value of the improvements to the land — not the land itself. By this, the IRS typically means the house. If your home burns down, the land will still be there. That land has value that doesn’t depreciate.
You need to know the value of the land and the value of the improvements. These values are mostly defined by the county and are described in your property tax assessment. You can look them up on your county government’s website, since this is public data. The breakdown is also often in the closing papers you get when you buy the property.
Often, 15–25% of the tax-assessed value of residential real estate is given to the land, and 75–85% goes to the improvements. Say you own a rental property assessed at $100,000. Break it down and you might have $80,000 in improvements and $20,000 in land value. So, $80,000 is depreciable — not the full $100,000.
How it works
For residential properties, the IRS has said that the useful lifespan is 27.5 years. You can deduct tax up to the cost of the property over that time.
Take the example in which the home has a value of $80,000. You take away tax of $2,909 each year ($80,000 ÷ 27.5 years). Say your net annual rental income is $8,300. Your taxable rental income goes down to $5,391.
Tax breaks for depreciation are not only for real estate. Assets bought and used by businesses can also depreciate in their IRS defined lifespan. For example, you can purchase a new printer for your business and depreciate its value over five years. You take the deduction each year as your printer gets older and loses value.
A unique point of real estate depreciation is that it is about an asset that does not often lose value. In fact, property values tend to go up over time. That means you get a tax credit on the cost of an asset that may be going up in value, not down.
What’s more, depreciation is a tax credit that is on top of property upkeep and other costs that you can take away from the rental income you get. When you take it, it provides a tax deduction that lowers your tax liability. That means more money that you can use to buy more properties, pay off the loan if you took one, pay for upkeep or anything else you want to spend it on.
Caution: “use it” or “lose it”
This tax break comes with consequences down the road. When you sell the property, the IRS takes back the tax that you would have paid over the years without the benefit of claiming depreciation.
The proceeds of the sale are subject to “depreciation recapture.” This part of your proceeds is taxed at your usual income tax rate. Not the capital gains rate.
The capital gains tax is a flat 15%. It aids most people to pay capital gains tax over income tax. The recapture tax rate is more than the capital gains tax rate.
So, you might be thinking to not take depreciation tax breaks. The IRS has a rule to stop this. When a person sells a rental property, the amount of depreciation that could have been taken will be calculated. That means it makes sense to take the break each year.
Depreciation has another benefit
There is one more good thing about depreciation. It can change a cash-positive rental to a loss on paper. That loss can reduce your other taxable income.
Take the same example as before. The depreciable sum of your rental property is $80,000. Your property brings in $11,000 a year in rent. Your yearly costs are loan interest payments of $6,000, county property taxes of $1,800, an insurance costs of $300, and upkeep costs of $600. The sum of the costs is $8,700 a year.
The depreciation deduction is $2,909 ($80,000 ÷ 27.5 years). So you have $11,000 in rent and costs of $11,609 ($8,700 in real costs plus the $2,909 tax deduction). This gives a “loss” of $609 on the property. This loss can be taken away from your earned income, such as your job.
The rules are laid out in IRS Publication 527. The recapture rules are in IRS Publication 946.
Like any other tax strategy, you must be careful to follow all the rules. For example, you can deduct depreciation only on the part of your property used for rental purposes. If you buy a duplex and rent out one side and live in the other, you may deduct depreciation only on the unit you rent out. Not the one you live in.
It helps to consult an accountant. This will make sure you are in line with the rules. It will also help to know which way of working out depreciation is best for you. Choose an accountant that works with real estate investors. You might get some great tax advice for your particular situation.