Particular financial benefits come from investing in rental properties. A few of them come into effect during tax time when investors get to deduct operating expenses, property taxes and so on. Not only that, there is another thing they can claim as a deduction— depreciation. This key tax deduction works differently from the others due to how the amount is calculated and how it’s applied. Also, failing to take a deduction for depreciation can make things problematic for you down the road. Because of this, it’s important for Fortuna rental property owners to grasp what depreciation is, how it works, 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 has prescribed that rental property owners should split those kinds of deductions across the useful life of the property. So basically, instead of a large one-time deduction, owners would be deducting a portion of their purchase and improvement costs (not operating or maintenance costs) each year for several years. This can considerably lower the amount of taxable rental income you write on your tax return, making depreciation worth the time it takes to calculate.
The owner of the property can begin taking depreciation deductions as soon as the rental property is placed in service, or another way to say it: when it’s ready to be rented out. That is certainly good news for property owners who have a vacancy right after buying the home or during renovations. The duration you continue to deduct depreciation depends on how long you own and use the property as a rental, and which depreciation method you use.
There are different depreciation methods that give different amounts. Anyone of them can be used 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). Generally, MACRS is used for any residential rental property placed in service after 1986. If you use this method then the cost to purchase and improve 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 compute how much your depreciation should be each year, you’ll need to figure out 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. What makes this number difficult to get is that you’ll 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. In most cases, you can use property tax values to find out what portion of the purchase price should be allocated for the house, or your accountant might elect to use a standard percentage.
As soon as you have the amount for the rental house alone, you’ll need to move a step forward and figure out your adjusted basis. A basis in a rental property can be revised 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 decrease as well, 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. Using your adjusted basis, you can start to 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. But things are more complicated since rental property tax laws can be complex and change quite a bit now and then. Based on this, it is clear that it’s best to work with a qualified tax accountant. They would ensure that depreciation is being calculated and applied correctly.
When you team up with Real Property Management Humboldt, we can connect you with accounting professionals who can help you solve your depreciation questions and more. Working together with our experts can help property owners make sure that there are no unpleasant surprises when tax time draws near. Feel free to contact us online or by phone at 707-444-3835. We’ll be glad to answer any questions you may have about our Fortuna property management services.
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