Residential real estate is a lucrative investment and has seen an increase in foreign investment in U.S. real estate. If you’re investing in residential real estate, you are mostly focused on property management, cash flow, and increasing the value of your assets for future sale. While it might sound like a bad thing, depreciation is actually an important tool for owners of rental properties that can provide tax benefits. Learn more about the depreciation of residential real estate below.
What is Residential Real Estate Depreciation?
Depreciation refers to the loss of value to a property as it ages and experiences the general wear and tear of life. Much like a car driven off the lot, a building experiences depreciation as soon as it is placed into any type of service or available to use as a rental. Any building experiences this, even when comparing commercial vs residential real estate. The exact depreciation rate varies from property to property, but most residential rental properties are estimated to depreciate at a rate of 3.64% every year for 27.5 years.
Depreciation does not apply to the actual land as it does not get “used up” in the same way, but you can depreciate any improvements to the tangible property even if they are not part of the building, like appliances and carpeting.
While this can seem less-than-ideal, residential real estate depreciation can actually be used as a tool that allows you to write off the property and any improvements you perform on the property as expenses on your taxes. That ultimately means more money saved for you.
Tax Write-Offs and Depreciation
Residential rental properties come with plenty of tax benefits. For example, you can deduct rental expenses from your rental income. This includes:
- Property taxes
- Mortgage insurance
- Home office expenses
- Travel expenses related to managing the property
- Professional services such as property management services
These are all deducted in the tax year that you actually spend the money for them, but depreciation deduction works a little differently. You can deduct the costs that go into buying and improving a property, but instead of deducting all of these expenses at once in the year that you actually spend the money, depreciation allows you to spread those deductions over the usable lifetime of that property.
Is Your Property Depreciable?
The IRS has specific rules in place that dictate how you can depreciate property and the requirements for depreciating a rental property. Your property is depreciable if:
- You are the owner of the property
- You use the property as a form of producing income or in your business in some way
- The property can physically depreciate and has a determinable useful life (the property can decay, wear out, get used, naturally lose its value, or succumb to obsolescence)
- The property will last more than one year
Your rental property doesn’t need to meet all of those requirements, but even if it does, there are still some exceptions. It is not eligible for depreciation if you placed the property into service and then stopped using it for business in the same year. Furthermore, you generally cannot depreciate the costs that go into planting, clearing, or landscaping as they go into improving the land, which, as mentioned, is not considered depreciable. However, you can depreciate the costs that go into management of the property itself. For example, if you enlist a company for property management in Gainesville, FL, the costs of these professional services can be depreciated.
The Lifecycle of Depreciation
A property can be depreciated as soon as it is placed into service or otherwise ready to use as a commercial or residential rental. Say you purchase a property January 1. You perform any necessary repairs and get the house ready and listed on March 1, but a tenant does not sign the lease and move in until May 1. Even though no one has moved in, you can technically start the depreciation March 1, which is when the property was ready to be rented out.
You can continue to depreciate the property until you have deducted your entire cost or other basis value in the property. Depreciation also stops as soon as you stop business or otherwise retire the property from service. A property is considered retired from service as soon as you stop using it to produce income. That includes:
- Selling or exchanging the property
- Abandoning the property
- Converting the property to personal use
- Destroying the property
You can still continue to depreciate costs when the property is idle, like when a tenant moves out and you are getting the property ready for a future tenant.
What Can You Depreciate?
You can, of course, depreciate the initial costs of buying the rental property, but you can also depreciate any costs that go into improving the property. An “improvement” is defined as anything that increases the value or usefulness of the property, adapts the property to a new use, or restores the property or part of the property to a better condition.
That is a fairly broad definition, which gives you a lot more room to depreciate just about anything you do to your property. Improvements that count in rental property depreciation include:
- Building a garage, storage, or other addition
- Installing new utilities
- Replacing the roof
- Adding carpeting
- Installing ramps and other accessibility upgrades
Any routine repairs and maintenance would not be depreciable as they are not considered improvements, but you can still thankfully deduct maintenance costs the year that you spend the money on them.
How to Calculate Depreciation
In simple terms, the IRS allows you to deduct expenses based on the decrease in property value over a 27.5-year period, which is considered the “useful life” of any given rental property. While you should work with a tax accountant or professional who can more precisely calculate depreciation, you can arrive at an estimate on your own with some basic steps. The method of depreciation calculation is as follows:
1. Determine the property’s basis value.
The basis value is simply the amount of money that you paid to obtain the property, whether it’s cash, a mortgage, or some other combination. This includes some closing costs and settlement fees, such as:
- Legal fees
- Transfer taxes
- Title insurance
2. Determine the building value.
The building’s value is the value of the land subtracted from the cost of the building. You need this amount as you cannot depreciate the value of the land. You can use the fair market value of both at the time of purchase.
3. Adjust the basis value, if necessary.
You may need to adjust the basis if something happens between when you buy the property and when you actually have it ready to rent to a potential tenant. For example, restorations to damage on the property or improvements that have a useful life of at least one year would increase the basis, while insurance payments from theft or damage would decrease the basis.
4. Calculate annual depreciation deduction.
Once you have the building value, simply divide it by 27.5 (the years of useful life for your rental property) to get the yearly allowable depreciation deduction.
This method of depreciation calculation is under the GDS (General Depreciation System), which applies to most properties and is what you should use unless instructed to use the Alternative Depreciation System (ADS). The ADS is required if the property is:
- Used for any tax-exempt purpose
- Used for qualifying business 50 percent of the time or less
- Used primarily as a farm
- Financed by tax-exempt bonds
With ADS, the useful life of a rental property is 30 years for any building doing business after Dec. 31, 2017, or 40 years for buildings in business prior to that.
Understanding rental property depreciation can help you save money in your investment and make the right choices for long-term deduction. Consult a professional accountant or property manager to learn more about depreciation. At Great Jones, we believe in equipping real estate investors with knowledge so you can make the best decisions for your property investment. For additional resources, check out our blog post on single family rental cap rates and how it affects your overall investment.