Depreciation is the process of allocating the cost of a rental property over its useful life for tax purposes. The calculation of depreciation for a rental property involves the following steps:
- Determine the property's cost basis: The cost basis is the original cost of the property, including the purchase price, closing costs, and any capital improvements made to the property.
- Determine the property's useful life: The useful life of a rental property is the estimated period of time that the property will be used to generate income. For tax purposes, residential rental properties have a useful life of 27.5 years, while commercial properties have a useful life of 39 years.
- Calculate the annual depreciation allowance: The annual depreciation allowance is calculated by dividing the property's cost basis by its useful life in years. This amount represents the portion of the property's cost that can be written off each year for tax purposes.
- Calculate the adjusted basis: The adjusted basis is the cost basis minus any depreciation taken in previous years. This amount will be used to calculate the depreciation in future years.
- Repeat the calculation in future years: The depreciation calculation should be repeated each year to determine the annual depreciation allowance and adjusted basis.
How to Determine a Rental Property's Cost Basis
A rental property's cost basis is the amount used to determine the gain or loss from the sale of the property. The cost basis includes the purchase price, any closing costs and any capital improvements made to the property.
To determine the cost basis of a rental property:
- Start with the purchase price: This includes the price paid for the property, as well as any closing costs, such as legal fees and title charges.
- Add capital improvements: This includes any upgrades or renovations made to the property that add value to it, such as a new roof or bathroom remodel.
- Subtract any depreciation taken: If the property has been depreciated for tax purposes, subtract the total amount of depreciation taken from the cost basis.
The cost basis is used to calculate the gain or loss on the sale of the property, which is then used to determine the amount of tax owed (or refund due) on the sale.
Related Reading: Can You Avoid Capital Gains Tax on a Rental Property
How to Determine a Rental Property's Useful Life
The useful life of a rental property is the estimated length of time it will generate income, typically in years. It is used to determine the amount of depreciation that can be claimed on the property for tax purposes.
To determine a rental property's useful life:
- Consider the type of property: Different types of properties have different expected useful lives. For example, a residential rental property may have a useful life of 27.5 years, while a commercial property may have a useful life of 39 years.
- Review IRS guidelines: The IRS provides guidelines for determining the useful life of rental properties, which vary depending on the type of property. These guidelines can be found in IRS Publication 946.
- Consider the physical condition of the property: The physical condition of the property can impact its useful life. For example, a well-maintained property may have a longer useful life than a property that has not been well-maintained.
- Consult a professional: An experienced real estate professional or accountant can provide valuable insights and guidance on determining the useful life of a rental property.
It's important to note that the useful life of a rental property can be adjusted over time as the property ages or conditions change.
How to Calculate the Annual Depreciation Allowance on a Rental Property
To calculate the annual depreciation allowance on a rental property, you need to determine the cost basis of the property, its useful life, and the depreciation method you want to use. Here is the process for calculating the annual depreciation allowance using the Straight-Line Method:
- Determine the cost basis: Add up the purchase price of the property, any closing costs, and the cost of any capital improvements made to the property.
- Determine the useful life: Review IRS guidelines and consider the type and physical condition of the property to determine its estimated useful life in years.
- Determine the residual value: Estimate the value of the property at the end of its useful life.
- Calculate the depreciable amount: Subtract the residual value from the cost basis to determine the depreciable amount.
- Calculate the annual depreciation allowance: Divide the depreciable amount by the useful life of the property in years to determine the annual depreciation allowance.
Example:
- Cost basis: $200,000
- Useful life: 27.5 years
- Residual value: $10,000
- Depreciable amount: $200,000 - $10,000 = $190,000
- Annual depreciation allowance: $190,000 ÷ 27.5 years = $6,909.09
Note: This is just one method of calculating the annual depreciation allowance on a rental property. Other methods, such as accelerated depreciation, may produce different results. Consult a professional for guidance on the best method for your specific circumstances.
Related Reading: Is Landlord Insurance Tax Deductible?
How to Calculate the Adjusted Basis on a Rental Property
The adjusted basis of a rental property is the cost basis of the property, increased or decreased by certain events, such as capital improvements or the taking of depreciation deductions. Here's how to calculate the adjusted basis of a rental property:
- Determine the original cost basis: This includes the purchase price, closing costs, and any capital improvements made to the property before it was placed in service.
- Add capital improvements: Capital improvements increase the adjusted basis of the property. Capital improvements are upgrades or renovations made to the property that increase its value and extend its useful life.
- Subtract depreciation deductions: Depreciation deductions decrease the adjusted basis of the property. Depreciation is a non-cash expense that spreads the cost of the property over its useful life.
- Reflect any changes in value: If the property is damaged or destroyed, or if it is sold, the adjusted basis should be adjusted to reflect the change in value.
Example:
- Original cost basis: $200,000
- Capital improvement: $10,000
- Depreciation deductions taken: $15,000
- Adjusted basis: $200,000 + $10,000 - $15,000 = $195,000
It's important to keep accurate records of all changes to the adjusted basis of a rental property, as the adjusted basis is used to calculate the gain or loss on the sale of the property, and to determine the amount of tax owed or refund due on the sale.
What is the Straight-Line Method of Depreciation on Rental Property?
The most common method for calculating depreciation on rental property is the Straight-Line Method, which uses the following formula:
Depreciation expense = (Cost of the asset - Salvage value) ÷ Useful life of the asset (in years)
What is the MACRS Method of Depreciation on Rental Property?
The IRS calculates depreciation on rental property using the Modified Accelerated Cost Recovery System (MACRS). This is a tax depreciation system that allows taxpayers to recover the cost of assets used in a trade or business over a specified period of time, based on IRS-determined lives for different types of assets.
Accelerated depreciation is a method of calculating depreciation that allows a higher deduction in the early years of an asset's useful life and a lower deduction in the later years. This method reflects the fact that assets typically lose more value in their earlier years. In the case of rental property, accelerated depreciation can be used to write off a larger portion of the property's cost in the first few years, thereby reducing taxable income and increasing tax savings.
To calculate depreciation on a rental property using MACRS, you need to determine the cost basis of the property, its useful life, and the depreciation method you want to use. There are two methods for calculating depreciation under MACRS: the Straight-Line Method and the Accelerated Method.
- Straight-Line Method: This method calculates depreciation by dividing the cost basis of the property by the number of years in its useful life.
- Accelerated Method: This method calculates depreciation at a faster rate than the Straight-Line Method, by using a declining balance method.
The choice of method will depend on the type of property, the taxpayer's tax bracket, and other factors. To determine the best method for your specific circumstances, it is recommended to consult a tax professional.
Once the method is chosen, you will need to complete IRS Form 4562 to report the depreciation on your tax return. The form requires information on the cost basis, useful life, depreciation method, and other details of the rental property.
Note: The above is a general overview of how the IRS calculates depreciation on rental property. The rules and procedures for calculating depreciation can be complex and may change from year to year. It is important to consult a tax professional for guidance on your specific circumstances.
It is important to note that the calculation of depreciation for rental properties can be complex and may involve various tax rules and regulations. It is always advisable for property owners to seek professional tax advice to ensure compliance with all applicable tax laws.