What Happens When You Depreciate a Rental Property?
Depreciation is one way that you recover the cost of an investment in rental property. Depreciation refers to an asset’s gradual reduction in value as it ages. The United States tax code allows you to claim annual depreciation on your rental property. Understanding how depreciation works and how it affects your tax liability can help you to properly file your taxes and plan your finances.
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Rental Property Depreciation
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The Internal Revenue Service (IRS) allows you to depreciate assets such as rental property, as these assets eventually wear out and require replacement. For a rental property to qualify for depreciation, you must own the property and use it to produce income, the property must have a determinable lifespan and you must expect the property to last for more than one year. You cannot depreciate land, as it does not wear out. You can depreciate some land improvements, such as landscaping.
Annual Tax Savings
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The primary effect of depreciation is to reduce your annual tax debt by reducing your taxable income. For example, if you had $10,000 in rental income from a property and claimed $2,000 in depreciation, you would only pay income tax on $8,000 for the property. In general, the IRS allows you to depreciate residential rental property over a period of 27.5 years and commercial rental property over a period of either 31.5 or 39 years. This means that you can claim depreciation on your taxes for this amount of time or until you sell the property.
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Other Depreciation Methods
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There are ways to depreciate some of the assets of a rental property over a shorter period of time, capturing tax savings from the property more quickly. For example, a process called cost segregation separates the property into pieces to determine the proper rate of depreciation. For example, the building’s structure may depreciate over 27.5 years, but other parts of the building will depreciate more quickly. Due to the complexity of depreciating real estate and choosing the best method for your specific situation, it is advisable that you hire a tax professional to assist you.
Reduced Cost Basis
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One negative effect of depreciating a rental property is that depreciation will reduce its cost basis. For example, if you purchase a rental property for $500,000 and claim $50,000 in depreciation during the years that you own the property, your cost basis for the property will be $450,000. When you sell the property, you may have a larger capital gain after depreciating the property. However, as most taxpayers pay a higher rate of taxation on income than capital gains, it is less costly to pay capital gains taxes.
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