There are several financial benefits of investing in rental properties. There are a few that get to be realized during tax time when investors get to deduct operating expenses, property taxes, and so on. But in addition to all these benefits, investors also get to deduct 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 the potential repercussions, it’s important for Newbury Park rental property owners to fully understand depreciation, how to use it properly for your benefit, 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. 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 greatly lessen the taxable rental income amount that you report on your tax return, making depreciation worth the time it takes to calculate.
Property owners can begin taking depreciation deductions as soon as the rental property is placed in service, or to simply put: when it’s ready to be rented. That is great news for property owners who have to deal with a vacancy right after purchase or during renovations. The number of years you’d spread the depreciation cost depends on two things. First, how long you own and use the property as a rental, and second, which depreciation method you use.
There are different depreciation methods. Each one can 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). Typically, 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 year-on-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 a bit 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.
As soon as you get the amount that’s just for your rental house, you’ll need one more step. That is to figure out your adjusted basis. A basis in a rental property could be adjusted 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. 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. However, it’s a bit more complicated since rental property tax laws can be complex and change quite a bit every few years. Since this is the case, it’s best to work with a qualified tax accountant to ensure that depreciation is being calculated and applied correctly.
When you employ Real Property Management Ventura County, we can have accounting professionals guide you through 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. To know more about what our Newbury Park property management services can do for you, please contact us online or give us a ring at 805-387-3682.
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