Kevin Michels, CFP®, EA
The ability to depreciate a rental property is one of the many attractive benefits of owning rental real estate. The depreciation deduction reduces the rental income subject to taxation which increases the after-tax rate of return on the rental property.
Think of the depreciation deduction as an annual allowance for the wear, tear, and deterioration of a rental property. The IRS provides a uniform way to deduct that wear, tear, and deterioration from the rental income received each year.
Assume you complete a cash purchase of a $200,000 investment property that you will rent. You’re able to rent the property for $15,000 per year. Your expenses include some routine maintenance and repair, a monthly HOA fee, property taxes, and a few other miscellaneous expenses for a total of $4,000 of expenses your first year. In this scenario your net income would be $11,000, which is the difference between your rental income ($15,000) and your expenses ($4,000).
In addition to the deductible expenses associated with operating your rental property the IRS allows you to take a depreciation deduction to further offset your taxable income. Calculate your depreciation deduction as follows:
Step 1: Determine your adjusted cost basis in the property
Your cost basis is simply the original value of the property, or how much you paid for it. Include in that value any commissions or fees you paid to acquire the property. In addition, you can add to the cost basis any cost paid to make improvements to the property. Each year your rental property is in service you will decrease your adjusted cost basis by your depreciation deduction.
Continuing with the same example above, let’s assume your cost basis is $200,000 since you paid $200,000 for the property and no improvements were needed.
Step 2: Separate your adjusted cost basis between the land and building
Since land is not considered a depreciable asset, you will only be able to depreciate the building. If you don’t know the value that should be attributed to the land and building you can base the values on the most recent real estate tax assessment.
In our example we’ll assume the building is worth $160,000 and the land is worth $40,000
Step 3: Divide your adjusted basis in the building by 27.5 to figure your annual depreciation
The IRS stipulates that you can depreciate your rental property over 27.5 years. For every full year a property is in service you can take your full depreciation deduction. Once your adjusted basis is depleted you can no longer depreciate your property.
Since we can only depreciate the building our annual depreciation deduction would total $5,818. Calculated by dividing the basis in the building ($160,000) by 27.5.
Our $11,000 of taxable income is now reduced down to $5,182. Assuming a 25% Federal tax rate the final tax liability on your rental income will be $1,296 ($5,182 taxable income x 25%).
The rate of return for the first year you place your rental property in service would be 4.8% ($9,704 of after-tax income / $200,000 initial investment).
Each year you can take your depreciation deduction until you have completely exhausted the entire basis in your rental property.
However, it’s important to keep in mind that while depreciation helps reduce current taxable income, it also increases your capital gain if and when you decide to sell your rental property.
When you sell your rental property you will be taxed on the entire gain associated from the sale which is calculated by subtracting your adjusted basis from the sale price of the home. Since depreciation decreases your adjusted basis in the property, the gain generated by the sale increases.
Continuing with the prior example, let’s assume you rent out your property for 10 years and then decide to sell. At this point you’ve taken $58,180 in depreciation ($5,818 annual depreciation x 10 years) and your adjusted basis is now $141,820. In those ten years the fair market value of your property has increased to $270,000 which is what you sell it for. Your capital gain is $128,180 ($270,000 sale price - $141,820 adjusted basis).
Depreciation recapture stipulates that all gain attributed to depreciation is taxed at a flat 25%. In this case that would generate a tax bill of $14,545 ($58,180 of total depreciation x 25%). The rest of the gain is taxed using the capital gains rate. We’ll assume in this case it is taxed at a 15% rate. The capital gains tax liability will be $10,500 ($70,000 capital gain x 15%). The total tax liability on the sale of the property will be $25,045.
Depreciation works for your benefit while you are renting out your property. It reduces your taxable income and overall tax liability. However, because you must decrease your basis each year by the amount of depreciation you take you will most likely be hit with a pretty large tax bill if and when you decide to sell your rental property.