The main reason for anybody to invest in real estate is to save taxes. However, it is important to know the rules and regulations that govern real estate so that one can claim the maximum deductions available and save taxes to a reasonable extent.
Concept of depreciation
While filing income tax returns on form 1040, all expenses and income are recorded on the Schedule E form. The total net profit or loss is recorded in this 1040 form. If one incurs a loss, then it can help to lower the total taxable income. Depreciation is one of the major sources of expenses that are recorded in the form of 1040.
When one owns a property, there are two kinds of expenses that one incurs. One of them is the maintenance expenses which are quite infrequent. These could be gardening, repairs, electricity and other expenses which are related to maintaining a particular property. The other type is the cost that is incurred for improvement of the property like setting up a new kitchen or developing sidewalks along the pavement of the property. These costs have value for more than one year and hence there needs to be capitalized and depreciated.
The usual practice is to divide the total improvement costs by the life of these costs and to write off one part of the expenses every year. For example, if these expenses are $15,000 and the useful life is 15 years, then $1000 can be written off every year as part of depreciation expenses. When a rental property is purchased and is aimed to be used for more than one year, then the costs must be depreciated. One should note that only the price of the building can be used for claiming depreciation and not the price of the land as the land portion is not used up as much as the building portion.
The actual calculation
For example, if the total value of the property is $200,000 of which the land cost is $75,000 and the building cost is $125,000, then the depreciation can be calculated only for $125,000. For residential properties, the IRS allows a useful life of 27.5 years. Hence the total depreciation cost that is incurred every year is $4,545 ($125,000/ 27.5). This depreciation when multiplied with the incremental tax component, can give a tax savings of a maximum of $2,000 for the depreciation amount.
The calculation of the property value and the depreciation expenses for a year looks pretty simple, but it can get really complicated when analyzed further. The taxpayer should have a flair for number crunching to get the basics and the calculation right. The IRS suggests that having a licensed and professional tax advisor comes in handy during these times. It is not only important to know the tax rates but also to know how to claim these costs so as to get some tax savings. To know these tricks, one should be highly fluent in the residential property tax rules.