What is Real Estate Depreciation?
Real estate depreciation is making gradual deductions in the value of a real estate asset until it becomes obsolete. It allows investors to seek tax deductions. There is no actual cash flow involved when accounting for depreciation.
It merely reflects the present valuePresent ValuePresent Value (PV) is the today's value of money you expect to get from future income. It is computed as the sum of future investment returns discounted at a certain rate of return expectation. of an asset by accounting for any wear and tear during its lifetime. DepreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. helps lower one’s tax liability and recover the cost of property improvements or maintenance.
Table of contents
- Real estate depreciation refers to the deductions in the value of a real estate asset to account for the depreciation in its value owing to its use during its lifetime. It can be used to claim tax deductions over the income generated from the asset and recover the cost of improvements.
- The Internal Revenue Service (IRS) has specific rules and regulations that govern the depreciation and tax deduction claims on such properties.
- An important rule is that while determining the total basis for depreciation, the value of the land is not included, as depreciation accounts for assets that wear out over time. Land appreciates.
Real Estate Depreciation Explained
Real Estate Depreciation is a crucial tax-saving tool. As per the IRS, depreciation can be understood as recovering the cost spent to acquire an asset until it is recovered. The mechanism involves an asset such as a building which is depreciated every year. The appropriate rate is applied to the acquisition cost of the property, which gives the value of depreciation. This amount is deducted annually. There is no actual cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. involved when accounting for depreciation.
It merely reflects the present value of an asset by accounting for any wear and tear during its useful life. There is no actual cash flow involved as the account is only recorded in the books of the account. For the income generated from properties, depreciation helps lower one’s tax liability as the depreciation value can be deducted from the earningsEarningsEarnings are usually defined as the net income of the company obtained after reducing the cost of sales, operating expenses, interest, and taxes from all the sales revenue for a specific time period. In the case of an individual, it comprises wages or salaries or other payments..
Moreover, depreciation is also used to recover the cost of improvements or maintenance of the property. The deduction ends if the asset becomes obsolete or is sold out. It also stops when one recovers the cost after gradual deductions over years.
How to Calculate?
The Internal Revenue Service (IRS) has defined a step-wise process to calculate real estate depreciation. This process informs investors on how much they can depreciate each year. The following are the steps involved –
- Determining the eligibility for depreciation is the foremost step. There are many crucial criteria. Some of them are that the investor must own the property, the property must inherently depreciate, and the property must be employed for income-generating activities like leaseLeaseLeasing is an arrangement in which the asset's right is transferred to another person without transferring the ownership. In simple terms, it means giving the asset on hire or rent. The person who gives the asset is “Lessor,” the person who takes the asset on rent is “Lessee.”, etc.
- The next step involves calculating the basis of the acquisition cost. It includes installation charges, freight charges, fees, etc. Any cost of land included in the building must be deducted. Also, make any additions or deductions from this value to account for any costs or earnings on the property until it’s ready for rent. This becomes your adjusted basis.
- After that, investors need to select an appropriate depreciation method. For example, under the Modified Accelerated Cost Recovery SystemModified Accelerated Cost Recovery SystemMACRS (Modified Accelerated Cost Recovery System) is a tax-related depreciation system used in the United States that allows for a higher depreciation deduction in the early years and a lesser depreciation deduction in the later years. (MACRS), the IRS has specified two methods, General Depreciation System (GDS) and Alternative Depreciation System (ADS).
The recovery period is 27.5 years, depreciating at 3.636% each year for residential rental property under the GDS. The period is 30-40 years under the ADS. Therefore, the MACRS has been the suggested method for the residential rental property since 1986.
- The specified rate is then applied to the cost of the property or the adjusted basis to attain the depreciation value. After accounting for all the income and expenses generated on the property, one deducts the depreciation value. It brings down the taxable incomeTaxable IncomeThe taxable income formula calculates the total income taxable under the income tax. It differs based on whether you are calculating the taxable income for an individual or a business corporation..
Example (Step by Step)
Let’s walk through an example to determine how much we depreciate our real estate assets each year. Of course, real estate depreciation calculations can be elaborate at times; some investors prefer working their way through a sufficing calculator.
Let us assume Mark bought a single-family home in January 2020. Then, in January itself, he rented it out at $150,000.
Step #1 – Determine the Cost Basis
The basis of a real estate asset is defined as the total amount paid to acquire the property. For example, Mark’s property is for $150,000. This is around $158,000 when all financing, due diligence, legal, and closing fees are added.
After you have a total cost basis, you must deduct the land cost. So, in our example, Mark’s property was last assessed at $120,000, and the assessor valued the house at $90,000 (75% of value). Therefore, the land was valued at $30,000 (25%). This 25% can then be deducted from the total $158,000 to get Mark’s current cost of the property which is $118,500.
Finally, Mark would need to account for any improvements or earnings generated on the property. Improvements include the cost of restoring damages and rehabilitating. In our example, Mark invested $10,000 to make the property ready for rent, and his adjusted basis is around $128,500.
Step #2 – Determine the Method
Most properties are depreciated by using the GDS methodology. Some properties qualify for ADS too. ADS is used for unique circumstances like tax-exemptTax-exemptTax-exempt refers to excluding an individual's or corporation's income, property or transaction from the tax liability imposed by the federal, local or state government. These exemptions either allow total relief from the taxes or provide reduced rates or charge tax on some items only. use, etc. Since GDS applies to residential rental properties in service post-1986, Mark will use the same.
Step #3 – Determine the Recovery Period
Mark’s recovery period will be 27.5 years under the GDS method.
Step #4 – Determine the Depreciation Amount
The depreciation amount equates to 3.636% of the adjusted basis depreciated each year. In our example, Mark’s asset was ready for service in January and would depreciate by $4,672 each year. After accounting for income and expenses involved with the property, Mark can deduct this amount to lower the taxable income.
Rental property depreciation, when claimed, is a huge tax benefitTax BenefitTax benefits refer to the credit that a business receives on its tax liability for complying with a norm proposed by the government. The advantage is either credited back to the company after paying its regular taxation amount or deducted when paying the tax liability in the first place.. Let’s again assume the tenant pays Mark $15,000 in rent annually. Mark’s property expense of insurance and other maintenance cost was $3000. If we depreciate the asset for $4672, it reduces Mark’s profit to $7328.
Had there not been a depreciation account, Mark would have to pay taxes on $12000 instead of $7328. It reduces tax liability, enticing many investors to use depreciation as a tool in tax planning.
Frequently Asked Questions (FAQs)
Depreciation is calculated by determining the cost basis and the total amount paid to acquire the property. This includes any installation costs, attorney fees, etc. If the cost of land is also included, it needs to be deducted from the cost of the building. Also, make any additions or deductions from this value to account for any costs or earnings on the property until it’s ready for rent. Then, calculate the depreciation amount using the appropriate IRS rate and method suggested.
Depreciation for improvements could be things like fencing, carports, lighting, or other equipment that may be on the land. Inside the building, you might be buying things like appliances, window coverings, floor coverings, and even things like the wiring of the building. So you need to do a cost segregation study and apply the appropriate depreciation rate and method to deduct improvements.
According to the IRS, the depreciation rate is 3.636% each year. The recovery period varies as per the method of computing depreciation. It is 27.5 for residential rental properties under the General Depreciation System and 30 or 40 years under the Alternative Depreciation System.
This has been a guide to what is Real Estate Depreciation. Here we explain it with an example along with how to calculate steps and its taxation benefits. You may also have a look at the following articles to learn more –