If you’re planning on becoming a real estate investor, chances are you’ve already looked into the tax perks that come with it. Owning a rental property is already a lucrative investment in itself, allowing you to generate excellent revenue each month. But thanks to depreciation’s effect on your taxable income, you can enjoy an even greater income.
In this article, we’ll give you a rundown on segmented depreciation, including how it works and how it can benefit property investors.
What is Segmented Depreciation?
When most property owners first hear the word ‘depreciation’ they usually think it’s a bad thing. After all, it does deal with the loss of value. However, real estate depreciation allows you to lower your taxable income by deducting the combined cost of the purchase price (how much you paid for the property) and the costs from improving the property (eg. repainting, remodeling, etc.).
It’s called segmented depreciation because you aren’t just deducting a one-time tax based on the property’s value in the year that you bought it. You’re distributing the deductions over a 27.5-year period, which is what the Internal Revenue Service (IRS) considered to be the standard “useful life” of a rental property.
How Can You Tell if Your Property Qualifies for Rental Property Depreciation?
For your rental property to qualify for depreciation deductions, the IRS requires that it meets four criteria:
- You legally own the property. You must not be renting it. However, it’s acceptable if you’re under an installment agreement until you take full possession of the property.
- You are using the property to generate income. This typically means that you’re leasing it to tenants and collecting monthly rent.
- It must have a “useful life” as deemed by the IRS. Residential properties have a useful life of 27.5 years, while commercial properties have a useful life of 39 years. Assets are considered to have a useful life if they are subject to loss in value, wear and tear, damage, etc.
- Its useful life must exceed one year. In other words, the property must be intact for one more year.
Additionally, only structures qualify for depreciation deductions. The IRS won’t allow you to depreciate costs involved with land, such as landscaping, lawn leveling, soil treatment, and so on. The best way to determine the accurate value of your property, minus the land that it is built on, is to hire a professional appraiser or property manager.
What Costs are Counted in the Cost Basis?
Generally, cost basis can be arrived at by combining the purchase price and the costs of improvements that you make to the structure, but other costs can be included, such as:
- Debts that you assume. For example, if you assume a $10,000 loan owed by the seller, the $10,000 will be counted as a cost.
- Legal expenses involved while acquiring the real estate investment.
- Property assessment/surveying costs.
- Taxes for transfer of title
- Costs for title insurance
The amount that you end up with after deducting all of the costs is called the cost basis. The cost basis can change over time, as it is expected that you will make additional improvements to the property as renters come and go.
For example, if the original cost basis was $200,000, but you then spent $50,000 on renovations, such as installing new flooring and roofing, then your adjusted cost basis would be $150,000.
How is Depreciation Calculated?
Calculating depreciation is pretty straightforward. For residential rental properties, simply take your cost basis and then divide it by 27.5 or the IRS-determined useful life of the property. For instance, if your cost basis is $150,000, then your annual depreciation expense would approximately be $5,455.
For commercial properties, simply divide the cost basis by 39. Following the same example of a cost basis of $150,000, the amount of depreciation for each year that you own the rental would be around $3,846.
As you can see, calculating the annual depreciation is easy — it only gets complicated if you own the property for only a fraction of the year. The IRS provides a guide for the cost basis percentage that you can depreciate based on the month that the property was owned.
When Does The Property Start to Depreciate?
Rental property depreciation starts the moment that a property is ready for its first renters. To illustrate, if you purchased a property on January 2, spent a few weeks on home improvements, and then advertised it online on February 12, your property would begin to depreciate in February. This is because the property was already tenant-ready by the 12th of February.
Additionally, if you decide temporarily “close” your property after a tenant moves out, you can continue to claim depreciation deductions. Your property continues to depreciate even while you’re preparing your property for its new renters.
Why Do Real Estate Investors Love Depreciation?
Among the tax deductions enjoyed by property investors, rental property depreciation is one of the biggest deductions that they can enjoy. This is because properties can still be deemed “profitable” even if, technically, it incurred loss during the year. Low-profit properties enjoy the massive tax deductions brought by depreciation. For example, if your rental property generated $10,000 in annual income, minus the expenses, a $3,000 depreciation expense would exponentially reduce the taxable income to a mere $7,000. That’s a lot of money saved.
Other Tax Perks
Rental property depreciation isn’t just the only tax deduction you can enjoy. Property investors are treated to a plethora of deductible expenses that can reduce the overall taxable income, including:
- Property management services
- Advertising and marketing expenses
- Maintenance costs related to servicing systems (eg. HVAC units, toilets)
- Property taxes
- Transportation expenses related to traveling to and from the property
- Cleaning expenses
- Legal expenses
- Costs from obtaining and retaining renters
- Utility expenses (eg. water, electricity)
It’s important to keep in mind that the IRS considers repairs and renovations to be completely different. Repairs, such as fixing toilets, air conditioning units, etc., are counted as tax deductions. Meanwhile, renovations refer to cosmetic improvements such as repainting the walls or transforming the space into an open floorplan. Renovations are included in the cost basis.
It’s no wonder why so many people choose to invest in real estate. The tax benefits that come with rental property investment can help any landlord achieve long-term financial success.
If the numbers are too much to handle, Luxury Property Care can handle your taxes for you. Our team is composed of professional real estate brokers, accountants, and lawyers whose goal is to generate as much income from your rental as possible.