Depreciation is the annual "Expense Allocation" that the IRS allows you to deduct from the operating income of your investment real estate, even though it is not an actual cash, out-of-pocket expense.
The life of the property will determine how much you will be able to deduct each year.
There are two categories of depreciable investment properties.
The two categories are Residential Rental Property and Commercial Property.
They have different "lives."
Residential Real Estate has a depreciable life of 27.5 years, and Commercial Property has a depreciable life of 39.0, both of them being referred to as "investment property."
Let's look at an example...
You bought a warehouse for $280,000 and did $20,000 in renovations, for a total basis of $300,000.
But this is not your depreciable basis.
First, we must subtract out the value of the land, because the land is not a depreciable asset.
You assign a value to the land of $25,000.
This leaves you a Depreciable Basis of $275,000.
D = (PP + CI - LV / AL, where
D is the amount of allowable annual Depreciation,
PP is the Purchase Price,
CI is your Capital Improvements on the property,
LV is the assigned Land Value, and
AL is the Asset Life.
D = (280,000 + 20,000 - 25,000) / 39.0
D = 275,000 / 39.0
D = 7051.28
Your annual Depreciation Allowance will be $7051.28.
*Note: If this had been a Single Family Rental Home, Duplex, Triplex or Fourplex it is not considered commercial property therefore, your annual Depreciation Allowance would be $10,000 because of the 27.5 year life of the Residential Property.
How Much Does Depreciation Reduce Tax Liability?
If you rent real estate, you typically report your rental income and expenses for each rental property on the appropriate line of Schedule E when you file your annual tax return. The net gain or loss then goes on your 1040 form. Depreciation is one of the expenses you’ll include on Schedule E, so the depreciation amount effectively reduces your tax liability for the year.
If you depreciate $3,599.64 and you’re in the 22% tax bracket, for example, you’ll save $791.92 ($3,599.64 x 0.22) in taxes that year.
The Bottom Line
Depreciation can be a valuable tool if you invest in rental properties, because it allows you to spread out the cost of buying the property over decades, thereby reducing each year’s tax bill. Of course, if you depreciate property and then sell it for more than its depreciated value, you'll owe tax on that gain through the depreciation recapture tax.
Because rental property tax laws are complicated and change periodically, it’s always recommended that you work with a qualified tax accountant when establishing, operating, and selling your rental property business. That way, you can be sure to receive the most favorable tax treatment and avoid any surprises at tax time.
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