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Depreciation De-Mystified: An Introduction to Rental Property Depreciation

Dollar Bill Origami of a HouseThere are many financial benefits of investing in rental properties. Some come during tax time when investors get to deduct operating expenses, property taxes, and so on. But on top of all these benefits, investors also get to deduct depreciation. This key tax deduction works differently from the others because of the unique way it’s calculated and applied. Also, failing to take a deduction for depreciation can lead to problems down the road. This is the reason why it’s important for Magnolia rental property owners to know what depreciation is 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 recommended that rental property owners should distribute those kinds of deductions over the useful life of the property. To state it differently, owners shouldn’t have a one-time deduction of the purchase cost, but instead, they should be deducting a portion of their purchase and improvement costs (not operating or maintenance costs) each year for several years. This can substantially affect the amount of your taxable rental income that you place on your tax return, making depreciation worth the time it takes to calculate.

A property owner can begin taking depreciation deductions as soon as the rental property is placed in service, or stated another way: when it’s ready for rental. That’s favorable news especially if you’re a property owner who has to deal with a vacancy right off the purchase or during renovations. The amount of years that you’d take the depreciation is set by two things. The first one is how long you own and use the property as a rental, and the second one is which depreciation method you use.

There are different depreciation methods you can use 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). Usually, MACRS is used for any residential rental property placed in service after 1986. By applying this method, the expenses incurred to buy and improve a rental property spread out over 27.5 years, which is what the IRS considers to be the “useful life” of a rental house.

To determine how much depreciation you can claim each year, you’ll need to have 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 somewhat complicated 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 instances, you can use property tax values to help compute how much of the purchase price is for the house, or your accountant might elect to use a standard percentage.

When you’ve arrived at the amount designated for the rental house alone, you’ll have to do one more task— to figure out your adjusted basis. A basis in a rental property can be modified 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. It can also 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. Beginning with your 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 a bit more complicated since rental property tax laws can be complex and change quite a bit every few years. Because of this, it’s best to work with a qualified tax accountant to ensure that depreciation is being calculated and applied correctly.

When you avail of the services of Real Property Management Republic, we can get you in touch with accounting professionals who can address your depreciation questions and more. Coming together with our experts can help property owners make sure that there are no unpleasant surprises at tax time. Don’t hesitate to contact us online or give us a ring at 281-362-5001 to know more about what our Magnolia property management services can do for you.

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