The Benefits of Depreciation In Real Estate
Is depreciation a good thing? Yes, actually it is, especially if you own rental properties.
It’s well established that investing in rental properties can be a sound (and sometimes lucrative) financial decision. Not only can rental properties provide a steady source of passive income — hopefully while simultaneously appreciating and building equity — but there is also a multitude of tax benefits that landlords can take advantage of.
Owning residential rental properties is classed as a “passive activity,” and therefore doesn’t require the payment of self-employment taxes. It can, however, still generate a full-time income if done effectively. You can also deduct any rental expenses that you incur, from the rental income you receive — lowering your tax liability.
Other property expenses, such as including mortgage insurance, repair, maintenance costs, and property tax, can also be deducted in the year that you incur them.
What is Real Estate Depreciation?
Real estate depreciation is an income tax deduction that reduces an investor’s taxable income.
Real estate depreciation assumes that your rental property is subject to wear and tear over time, and therefore declining in value, of course, this isn’t usually the case — as long as you’re maintaining the property.
The impressive part about real estate depreciation is that few other investment options offer comparable depreciation deductions. This makes real estate depreciation an opportunity for investors to receive cash flow from the property — even if your taxes show a loss.
How Do You Depreciate Your Property?
You can start depreciating your property as soon as it is available to begin being used as a rental, regardless of whether a tenant is occupying it from that moment or not.
It is also useful to know that you can continue to depreciate the property until you have deducted your entire cost basis — or you retire the property from service. Your property will be classed as retired from service once it is no longer used to produce income, for example, if you sell it, decide to utilize it for personal use or if it is destroyed.
The IRS determines the useful life of a property for tax purposes as 27.5 years. The Modified Accelerated Cost Recovery System (MACRS) is an accounting technique that spreads depreciation deductions over the required 27.5 years, according to the IRS.
The most commonly used MACRS method for depreciating property is the General Depreciation System, in which you apply the depreciation rate against the non-depreciated balance. For example, in practice, if an asset is determined to have cost $100,000 and is depreciated at 25% every year, the first year’s deduction will be $25,000 and the next year $18,750 and so on.
How Does Real Estate Depreciation Benefit Investors?
Real estate depreciation is beneficial if you are a landlord and invest in rental properties, as it enables you to it spread out your initial investment of buying the property over 27.5 years, which reduces each year’s tax obligation.
If you’re considering adding rental property to your portfolio, it’s crucial that you understand the local real estate market. By seeking the advice of a knowledgeable professional with experience in the single-family home rental market, you can ensure that you make an informed decision.
If you have any questions regarding purchasing a single-family rental home, we would be happy to assist you! You can reach us here, and also check out our podcast for general financial advice and useful tidbits.
All information and materials in this article are for educational purposes only. Opinions expressed in this article are based on information considered reliable, but The Daily Money Show cannot guarantee the accuracy of the information, nor should it be relied upon. The information discussed in this article should not be used as a recommendation to buy or sell securities, nor should it be taken as investment advice. The Daily Money Show is not a Registered Investment Advisor or Broker Dealer. The Daily Money Show is not an accounting firm and does not give tax advice regarding any security or real estate transaction. You may want to consult with an accountant, attorney, real estate agent, or financial advisor before proceeding with any transaction regarding securities or real estate.