There are so many benefits to owning a rental property, including passive income and reductions in taxes. However, all landlords should know about the effects of rental property depreciation on their rental income and tax responsibilities.
Though the idea of certain items on your rental property losing value may seem like a bad thing, the depreciation of assets on a rental property can actually work to the benefit of rental property owners. Let’s learn more about rental property depreciation and what it could mean for you as a landlord.
What Does Rental Property Depreciation Mean?
Depreciation is the gradual eroding of an item or property’s market value. Depending on the item, depreciation rates can vary greatly from a few years to several decades.
For example, a piece of electronic equipment used for work — like a laptop — will generally have a “lifespan” of about five years, during which the laptop’s market value steadily decreases over each subsequent year of use.
Though you may not earn back what you paid for the laptop if you try to sell it a few years after purchase, the depreciation rate of the item will offset the revenue that you make by using it for work. You’ll be able to see decreases in what you owe during tax season thanks to depreciation.
Tax Benefits of Rental Property Depreciation
Rental property depreciation works the same way, though one significant difference is that the lifespan of a rental property is 27.5 years, according to the Internal Revenue Service (IRS).
The rate of depreciation will allow you as a property owner to deduct about 3.6% of your real estate’s cost basis from your yearly income as reflected on your tax returns. That means a 3.6% decrease in the amount of income that you can be taxed on each year for 27.5 years, or as long as you own the property.
Whether your work as a property owner and landlord is a source of passive income for you or your main source of income, this decrease in taxable income can make a huge difference come tax season.
IRS Requirements for Depreciation
The IRS sets certain criteria that property owners have to meet in order for their rental property to depreciate according to the standard of 27.5 years. Some of these criteria include:
- Legal property ownership
- Income generation from the property, generally from renting to tenants
- Ability to determine the property’s useful lifespan (land itself cannot depreciate)
- A useful property life of over one year
If you meet all of these criteria as a property owner, you’re able to claim property depreciation on your taxes and therefore reap the benefits.
If you flip homes as a part of your income, you likely won’t be able to depreciate your property because most property flippers own the real estate for less than a year.
Calculating Rental Property Depreciation
Though the IRS has its standard of 27.5 years of depreciation for a property, you can calculate the precise details of your rental home’s depreciation using a few different factors.
Calculate Your Cost Basis
The cost basis of your property is how much you paid to purchase it as well as any other expenses you’re responsible for in relation to the property. Cost basis does not include the value of the lot that your home is built on, as land does not depreciate over time the way buildings and items do.
Calculate Rental Property Depreciation
Once you’ve determined your property’s cost basis, divide it by the IRS standard depreciation of 27.5 years.
For example, if you combined the listing price of your property (minus the land value) with your ownership expenses and found that your cost basis was $150,000, you would divide that by 27.5 to get an annual depreciation reduction in taxable income of about $5,455.
Which Rental Property Items Depreciate the Fastest?
Did you know that some items on rental properties depreciate faster than others?
Things like furniture, appliances, and carpeting tend to depreciate in value faster than the home they’re used in. Their depreciation period is generally considered to be five years. Office equipment has a general depreciation period of seven years, and fences and roads depreciate over 15 years.