Residential rental property offers a number of benefits to the investor. It can provide healthy cashflow, the potential for appreciation and the ability to use other people's money. Also referred to as "leverage," the ability to buy real estate with borrowed cash lets the owner enjoy increased potential for appreciation, while also allowing him to buy more real estate with his money. Another benefit of residential rental property is depreciation, which is an excellent way to reduce tax liabilities.
Calculating the depreciation of a residential rental property is quite easy. Start with what you paid for the property, assuming that you used a combination of cash and a loan. Determine how much of the purchase price should be allocated to the land on which the property sits and how much to the actual buildings and improvements. Take the portion that is allocated to the building and improvements, and divide it by 27.5, which is the IRS's estimate of the useful life of a piece of residential property in years. The result of that division is your annual depreciation.
Benefits of Depreciation
Depreciation is a way to account for a property being "used up" over time. Although it can be problematic for companies who need to report their profits, since it reduces their profitability from an accounting standpoint, it is a boon to private property holders. Every year, you get to take thousands of dollars and subtract it from your property's income, saving you thousands in taxes.
Drawbacks of Depreciation
For the small residential real estate holder, depreciation has just one drawback. If the property is ever sold for a profit, the tax savings from the depreciation will need to be paid back under the guise of depreciation recapture tax. The recapture tax is at a rate of 25 percent, and applies if a property sells for a value that is above its depreciated cost. Property owners should note that recapture tax is due whether the property is depreciated or not -- the IRS will calculate the tax on the depreciation that you should have taken, whether or not you did.
For property owners who want to take more depreciation up front and increase their savings, cost segregation may be a good option. Cost segregation is a process where a property is separated into its constituent systems, and each of them is depreciated over its useful life. For instance, landscaping elements may only have a 15 year life, while kitchen appliances may last seven to 10 years. By doing this, the property's depreciation can be front-loaded to the beginning of its life. Given that many investors do not hold their real estate for its full 27.5 year life, this is especially valuable.
It is possible to defer, if not completely avoid, paying depreciation recapture tax. Investors who plan to buy more rental properties to replace any rentals that they sell can engage in a tax-deferred exchange as defined by section 1031 of the tax code. These "1031 exchanges" allow you to sell your real estate and buy more real estate without having to pay any capital gains or depreciation recapture taxes. However, you will carry your basis forward which means that you will only be able to depreciate the value of the new property that is above and beyond what you have already depreciated.