Depreciation in Rental Property: What it Is and How it Affects your Property

Depreciation in Rental Property: What it Is and How it Affects your Property

Most people consider cash flow when purchasing investment properties. However, there are additional benefits that are frequently overlooked: tax benefits and rental property depreciation. It can get complicated, but we want to make sure you understand everything.

What is Depreciation in Rental Property?

The term "depreciation in rental property" refers to the reduction in the value of rental property over time as a result of age, wear and tear, and deterioration. It's a systematic allocation of costs that could be used to deduct taxes. As a result, it contributes to tax reduction.

Depreciation of rental property is an "expense" that you can deduct from your taxes. It is one of the most significant benefits of real estate investing because it reduces reportable net income and thus taxes.

To claim depreciation, a taxpayer must own the property and, it must be placed in service for use in a trade or business or held for the production of income.

According to IRS, property is depreciated over a 27.5-year depreciation period, regardless of the economic life of the building. Land improvements are depreciated over a 15-year depreciation period.

Nonresidential real property is treated in the same fashion as residential rental property. Special rules apply to dispositions of rental property, including a recapture of depreciation when a taxpayer disposes of rental property by sale.

It's important to remember that you can't take extra depreciation deductions for rental property that you rent to your child or spouse, or any other person who is related to you in any manner specified by IRS code Section 267(b) or 707(b)(1).

Depreciation can be one of the biggest tax savings available on rental properties - but you want to do it correctly!

Calculating Depreciation In Rental Property

This formula is used to calculate depreciation:

Cost of the Building - Value of the Land = Building Value
Building Value / 27.5 = Yearly allowable depreciation deduction

For instance, the depreciation of a property worth $75,000 and land worth $25,000 would look like this;

$75,000 – $25,000 = $50,000
$50,000 / 27.5 = $1,818

You can also calculate for depreciation in rental property using depreciation for rental property calculator.

Cross Segregation

Landlords usually depreciate everything that can be depreciated over a 27.5-year period. That's quite some time. What if you decide to move things along quickly? You can use a technique known as cross segregation.

You can depreciate each item individually rather than grouping them all together. It's more complicated and requires a lot of detailed record keeping, however, it means a larger total yearly depreciation for the first few years of ownership.

The depreciation period for personal property and land improvements is shorter than the building, usually five or seven years, and thus can be depreciated more quickly.

The total deduction remains the same, but you receive it sooner; you receive it upfront rather than later.

Why would you do such a thing? Because if you invest that money, it has all the time to grow, and time has no substitute when it comes to making money through investing.

This is far too complicated for you to handle on your own. You can, however, hire an expert to handle it for you. It can be costly, so unless your property is worth more than $250,000, it's probably not worth it.

Passive Losses

In some cases, it's normal to run at loss on your rental property during the first few years. It is bad to lose money in any investment. However, it is different in rental property because it has tax benefits.

A loss in rental property is when your total operating expenses exceed your income from rent.

Sometimes, you can still have loss, especially for tax filing, if your property rental income exceed the expenses due to some annual deductions from depreciation

Passive losses can only be used to offset passive income; you cannot deduct them from earned income at your job, for example.

Rental losses are in jeopardy if you do not have enough passive income. You can only deduct them when you have enough passive income or sell the property.

Tax Write-Offs

Some expenses incurred from owning a rental property are tax-deductible.

Expenses for property maintenance and management, including payments for people who are employed to work for or on the property, such as property managers or contractors such as plumbers and electricians.

You can write off expenses such as property advertisement, commission paid to the broker who listed the property, and expenses incurred when bringing in tenants such as background and credit checks, as well as cleaning the property between tenants.

If you have out-of-state property, you can deduct some travel expenses as well. That doesn't mean you can buy one property in Hawaii, travel just to visit the beach for ten days, and then write it off completely.

The main purpose for the trip must be rental-related. These can include going to look at potential rental properties, going to deal with issues at an existing property such as repairs or showing it to potential tenants or going to meet with people who can help you with either transact or manage the property, such as management companies or real estate attorneys.

Travel expenses for things like sightseeing and recreational activities can't be written off.

1031 Exchange

A 1031 exchange allows a property owner to sell one property, use the proceeds to purchase another property, and defer capital gains taxes. This means that you can defer paying capital gains tax on your rental property until you buy another property.

Although there are rules to follow and criteria to meet, 1031 exchanges are one of the best tax avoidance strategies for investors.

Where to Hold Rental Property

If you own your rental property through a single owner LLC, only the assets of the LLC are at risk if you are sued, not your personal assets. This is why many property owners hold their properties in an LLC, but there are also tax benefits.

One of the advantages of an LLC is that it allows for pass-through taxation. Normally, a business is taxed directly on its profits, and the owners are taxed twice on the profit from the business.

An LLC allows the profit of the company to pass through the business owner, so all profit generated by the LLC is reported on your personal tax return, reducing the amount deducted from your earnings for taxes.

The IRS discourages mixing personal and business expenses. When you establish an LLC and open a bank account for it that is separate from your personal account, it is easier to keep the two separate during tax season.

What happens if you have a rental property in one state and live in another, or you have properties in more than one state? It is subject to the state in which the property is situated. You must disclose the income on your local, state, and federal tax returns, and you might also be obligated to pay local taxes depending on the location of your property.

Mistakes Owners Make

It is a mistake to place your property in an S Corp rather than an LLC because it means that you will still receive the income rather than a legal entity.

It's a big mistake to not properly depreciate your property. The IRS will presume that you have taken the deduction even if you weren't aware you could or simply forgot to. You might pay taxes on depreciation that you didn't benefit from, when you sell the property.

It's not too late to take it if you haven't already. You can add that lost depreciation to an amended return that you file.

Key Tax Strategies

The IRS classifies real estate income as passive income because it is derived from investments rather than from labor.

The income must be reported on your tax returns. However, you will deduct related expenses such as property taxes, mortgage interest, etc from the income.

Medical expense reimbursement plan and establishing an LLC through a 1031 exchange and cross segregation are good ways to avoid taxes. For some medical costs that traditional insurance doesn't cover, like dental and vision care, a MERP can be used as a deductible for your LLC.


Depreciation is the method by which you can recover the basis in a rental property over time. The basis is typically the purchase price and any costs to purchase and improve the property.

The amount of depreciation allowed on rental property is affected by the adjusted basis in the rental property. Basis will reduce the amount of depreciation you can claim on the property. You cannot depreciate the land that your rental property sits on.

Depreciation for rental property calculator will simplify your calculations and give you the correct amount.
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