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"Rental Property Depreciation: the Gift that Keeps on Giving"


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Rental property depreciation is one of the many rental tax deductions you can take advantage of while owning multi family houses. The beauty of investment property depreciation is that you deduct it even though you do not actually "pay" for it with your own money!

The only caveat is that when you sell you will have to pay taxes on all the depreciation you claimed under your ownership. But you'll still come out way ahead because it will be taxed at a lower rate (long term capital gains tax vs. ordinary tax).


WHAT IS DEPRECIATION?


Depreciation is an accounting (i.e., "paper") deduction that the IRS allows you to take for the overall wear and tear on your building. You can depreciate each of your multifamily properties over 27.5 years. The idea is that your property will deteriorate and will therefore need upgrading, rebuilding, etc., over time.

Of course, this is ironic because we all know that real estate appreciates over time and not the other way around. But hey, who are we to argue with Uncle Sam?

Note that rental property depreciation applies only to the structure and not the land on which it sits. The rationale is that land does not wear out, become obsolete, or get depleted and therefore cannot depreciate.


HOW DO I CALCULATE DEPRECIATION?


Obviously your accountant will do this for you, but I think it's still helpful for you to understand the methodology behind your investment property depreciation calculations.

Let's say you buy a triplex for $200K. The land is estimated to account for 20% of the total value, or $40K, so the structure is valued at $160K. Simply divide $160K by 27.5 years to calculate your annual depreciation deduction. In this case, you can write off about $5,818 each year.

One thing to keep in mind is that the calculation of depreciation can only begin when the property is ready for tenants. So if you buy a currently occupied investment property, depreciation begins immediately. If on the other hand you buy an unoccupied fixer upper, it'll only begin when the place is fixed up and ready to be rented.


CAN I CHOOSE NOT TO DEDUCT DEPRECIATION?


No, you have no choice!

It's critical to deduct your rental property depreciation each and every year, because the government automatically assumes that you do. Whether you take it or not, when you sell, you will have to reduce your basis by the full amount of the depreciation you could have deducted. This is called "depreciation recapture." The effect of reducing your basis is that your gain will look larger, which will increase your capital gain tax liability.

Let's go back to the previous example. Let's say you own that triplex for 10 years as per your long term investment strategy and you're now ready to sell. You've correctly deducted $5,818 in depreciation each year, for a total 10-year deduction of just over $58K. This will reduce the basis on which your taxable gain will be calculated to $142K ($200K-$58K).

You then sell the property for $300K, so your taxable gain is $158K ($300K-$142K). The gain consists of 2 parts: $100K in asset appreciation and $58K in depreciation recapture.

So again, when you sell, the IRS will assume that you previously deducted the $58K. Whether you did or not, it'll still be considered part of your taxable gain and you'll pay tax on it. The bottom line is that it would be foolish to not take advantage of your annual investment property depreciation deductions.



WHAT IF I FORGET TO DEDUCT DEPRECIATION?


Luckily, if you do make this mistake at least you'll have the ability to deduct past depreciation on your current tax return or amend your previous returns. The catch is that you can only go back 3 years. Another possibility is to have your accountant file IRS Form 3115 to change your accounting method to claim the correct amount of depreciation. In any case, you'll want to get the expert opinion of your accountant if you ever need to recover prior rental property depreciation.



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13 Responses to Rental Property Depreciation: the Gift that Keeps on Giving

  1. benson says:

    Do upgrades to my rental property decrease my capital gains liability?

    In 1999 I bought a home and have rented it to my son since the original purchase. The home was purchased for 79K then. We have updated the home since then to the tune of approx. 30k. Now, my son is wanting to purchase the home for his family. The tax appraisal comes in at 167,000. If I sell the home to him at face value (58K), does this qualify as a loss?

    • alank856 says:

      Hi,
      Thanks for checking out my site. Yes some upgrades increase your cost basis thereby reducing your capital gains liability when you sell. Your capital gains tax amount is calculated as the difference between your sell price and your adjusted basis. Your adjusted basis is basically the price you paid for the home, plus the costs of capital improvements, less things like accumulated depreciation, etc. I know, it is relatively complex which is why you’ll need to consult with your accountant. You can also get some more detail here: http://www.free-rental-property-investing-info.com/capital-gains-tax-investment-property.html.

  2. Sara says:

    Thanks for the info…very helpful!

  3. Ben says:

    What if you originally bought the property and lived in it for several years, and have now purchased and moved into a new property and have rented out the first. Does depreciation start when your first tenant moved in? Is the starting value what you paid years earlier or do you calculate depreciation for the time you lived there?

  4. joe bossie says:

    I inherited a small apartment building and formed an LLC effective June 1st of 2011. Only two of the twelve apts are occupied and I am remodling the kitchens and baths in hopes of getting better tennants. Can I still start depreciation at June 1.

    Thanks Joe

    • alank856 says:

      Hi – yes, depreciation starts the first day you own the property.

  5. joe bossie says:

    Thanks !!

  6. angus beefman says:

    I always found it odd that you’re forced to take depreciation. I can’t imagine a scenario where you wouldn’t want to take it anyway, but it seem strange to force it. That’s the gov’t for ya!

  7. Steven says:

    What if you did not take depreciation on the home when you brought it in 2006? Does the clock on the 27.5 years start now?

  8. Sandy Levy says:

    Am I forced to depreciate even though my losses are limited vs my K1. K-1 Income is between 100,000 and 150,000. No matter what losses my sch E is showing it is not carrying over to page one of 1040 – it still shows the same K-1 amount. Do I still have to depreciate – it is not making a difference in my refund?

  9. Marvin K says:

    I purchased an investment condo to rent out on a daily, weekly, and by the month in the winter. I rented it out on day one. I understand the regular depreciation but how about the bonus depreciation. I don’t think I am in a go zone. Am I eligible for this extra exemption? The IRS regulations are so confusing.

  10. Emily Louise says:

    My Mom is struggling to keep up with an old rental property.She is on a fixed income of $600 per month and lives in a nursing home.If the house forecloses (with a loan of $156k against it in my name)and sells for $110k how does she and I report this sale? I am not on the deed. She paid $100k for it and rented it for 15 years so $60k in depreciation so does she report the sale as $156 – $40k value after depreciation and then pay taxes on that or does she report the sale as $110k – $40k value after depreciation and then pay taxes on that? The bank would report the $46k difference to me due to the foreclosure ($156k loan – $110k sold)on a 1099 so do I just report that as credit card income since the house was only temp given to me to take out a loan against. I can’t report I bought the house or sold it because I didn’t do either. The other option we have is for her to gift me the house which means I could then at least work out a payment plan on the house so it would not go into foreclosure which is what I would like to do but how to do that on Form 709? Again, does she report the gift as $156(loan balance) – $40k value after depreciation and then does she pay taxes(you can exclude gift tax up to gifting away $1 million over your lifetime but do you still pay capital gains tax and income tax when you gift something) since it is a gift on that or does she report the sale as $110k(paid for) – $40k value after depreciation and then does she pay taxes (you can exclude gift tax up to gifting away $1 million over your lifetime but do you still pay capital gains tax and income tax when you gift something) since it is a gift on that. I would like to be able to keep the home and also could work out something with the bank and be able to claim homestead if it was in my name. I am very stressed out about this and if my Mom can’t afford to keep up with the house repairs and payments there is no way she could afford to owe the IRS $20k on capital gains,etc. Sometimes I wish I could just die so she could collect on my life insurance and pay off the $150k mortgage. I suffer from depression and this is really bringing me down. I would really appreciate any help or advice you could give me.Thank you and God Bless you.

  11. Cathy says:

    Back to your original explanation on depreciation….is the whole $158,000 taxed? Or just $58,000.

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