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Depreciation De-Mystified: An Introduction to Rental Property Depreciation

Dollar Bill Origami of a HouseThere are some financial benefits of investing in rental properties. A number of them are actualized during tax time when investors get to deduct operating expenses, property taxes, and so on. But there’s one more thing investors can deduct, and that is depreciation. This key tax deduction works differently from the others because, by its nature, it must be calculated and applied differently. Also, failing to take a deduction for depreciation can lead to some problems later on. This is why it’s important for College Station rental property owners to fully comprehend what depreciation is, how it affects your finances, and why you should be deducting it on your taxes every year.

In terms of buying and improving rental properties, depreciation is the process used to deduct any associated costs. Rather than take one large deduction in the year the property was purchased or improved, the IRS suggests that rental owners break the amount and spread those kinds of deductions over the useful life of the property. So basically, owners will not have one huge deduction but would be deducting a portion of their purchase and improvement costs (not operating or maintenance costs) each year for several years. This could largely reduce the value of taxable rental income that you report on your tax return, making depreciation worth the time it takes to calculate.

Property owners may begin taking depreciation deductions as soon as the rental property is placed in service, or in essence: ready to be used as a rental. That is some positive news for property owners who have to face a vacancy just after purchase or during renovations. The length of time you continue to take that depreciation is determined by two factors: How long you own and use the property as a rental, and which depreciation method you use.

There are different depreciation methods that use different approaches to determining the annual expense. You may use any of them to determine the amount you can deduct each year. But the most common one for residential rental properties is the Modified Accelerated Cost Recovery System (MACRS). Most often, MACRS is used for any residential rental property placed in service after 1986. By using this method, the expense of buying and improving a rental property is spread out over 27.5 years, which is what the IRS considers to be the “useful life” of a rental house.

To assess the amount of your depreciation you can deduct each year, you should know your basis in the property or the amount you paid for it. You may also be able to include some of your settlement fees, legal fees, title insurance, and other costs paid at the settlement. This number is a bit complicated since there is a need to separate the cost of the land from the building since only the rental house itself – and not the land it is built on – can be depreciated. Usually, you can use property tax values to calculate what amount of the purchase price should be designated for the house, or your accountant might elect to use a standard percentage.

When you’ve computed the amount just for the rental house, you’ll need to do one more thing, and that’s to figure out your adjusted basis. A basis in a rental property can be raised to account for things like major improvements or additions, money spent restoring extensive damage, or the cost of connecting the property to local utility service providers. The basis may likewise decrease in the event of insurance payments you received to cover theft or damage and any casualty losses you took a deduction for already that were not covered by your insurance. From the adjusted basis, you can now calculate the amount of depreciation you can deduct on your income tax return.

Depreciation of a rental property is a valuable tool for investors looking to reduce their annual tax obligation. However, it’s not very simple or straightforward since rental property tax laws can be complex and change quite a bit every so often. Because of this circumstance, it’s best to work with a qualified tax accountant to ensure that depreciation is being calculated and applied correctly.

When you work with Real Property Management Talent, we can have accounting professionals work with you and help you through your depreciation questions and more. Our experts can help property owners make sure that you are ready and that there are no unpleasant surprises at tax time. If you want to know more about our College Station property management services, don’t hesitate to contact us online or call us at 254-401-0400.

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