Depreciation is an accounting method that allows you to deduct the cost of a tangible asset (such as a property) over its useful life. In the context of real estate, it refers to the gradual loss of value of a property due to wear and tear, age, and other factors.
Depreciation works differently for primary residences, second homes, and rental properties:
It's important to note that when you sell a property that you have claimed depreciation on, you may be subject to depreciation recapture taxes. This means you will need to pay taxes on the amount of depreciation you claimed over the years, even if you did not receive that money as income.
To depreciate a property, you need to follow these steps:
Determine the cost basis of the property: The cost basis includes the purchase price of the property, plus any closing costs, such as title insurance or legal fees.
Allocate the cost basis: The cost basis needs to be allocated between the land and the building. The land cannot be depreciated because it does not wear out or become obsolete, but the building can be depreciated.
Determine the useful life of the property: The useful life of a property is how long it is expected to last before it needs to be replaced. The IRS has established guidelines for the useful life of different types of properties, which can be found in IRS Publication 946.
Determine the depreciation method: There are two methods for depreciating a property: straight-line and accelerated. Straight-line depreciation spreads the depreciation expense evenly over the useful life of the property, while accelerated depreciation allows for a larger deduction in the early years of ownership.
Calculate the annual depreciation expense: To calculate the annual depreciation expense, divide the cost basis of the building by the useful life of the property, and then multiply that amount by the percentage of the year that the property was in service.
The residential and commercial depreciation methods differ in their recovery periods and depreciation rates.
The residential depreciation method is used for properties that are classified as residential rental properties. It has a recovery period of 27.5 years and uses the straight-line depreciation method. This means that the cost of the property is divided equally over the 27.5-year period, resulting in an annual depreciation expense that is a fixed percentage of the original cost.
The commercial depreciation method is used for properties that are classified as commercial, industrial, or other non-residential properties. It has a recovery period of 39 years and uses either the straight-line or accelerated depreciation method. The straight-line method works the same as for residential properties, with the cost of the property divided equally over the 39-year period. The accelerated method allows for larger depreciation deductions in the earlier years of ownership, which can provide tax savings for property owners.
It's important to note that the depreciation method used for tax purposes must match the method used on the property owner's books. Additionally, the property must be used for income-producing purposes to be eligible for depreciation.
Depreciation can help taxpayers by reducing their taxable income, which in turn can lower their tax liability. By taking depreciation deductions over several years, taxpayers can spread out the cost of acquiring a business asset or income-producing property over the useful life of the asset. This reduces the amount of income that is subject to tax each year and can result in significant tax savings over time. Additionally, depreciation can help to offset any income generated by the asset, which can further reduce the amount of taxable income.
However, it's important to note that depreciation recapture rules may apply when the asset is sold, which can result in some of the tax benefits being "recaptured" or taxed at a higher rate.
Let's say you bought a rental property for $200,000 and claimed $50,000 in depreciation over the years. You then sell the property for $300,000. Your adjusted cost basis would be $150,000 ($200,000 - $50,000). The depreciation recapture would be the difference between the adjusted cost basis and the sale price, which is $150,000 ($300,000 - $150,000). You would owe taxes on the $150,000.
Suppose you bought a commercial property for $500,000 and claimed $150,000 in depreciation over the years. You then sell the property for $700,000. Your adjusted cost basis would be $350,000 ($500,000 - $150,000). The depreciation recapture would be the difference between the adjusted cost basis and the sale price, which is $350,000 ($700,000 - $350,000). You would owe taxes on the $350,000.