Property Management Blog

Key Takeaways

• Depreciation Lowers Taxes: Rental property owners can deduct depreciation over 27.5 years, reducing taxable income annually. However, this can lead to a depreciation recapture tax when selling.
• IRS Rules on Depreciation: Only the building, not the land, is eligible for depreciation, and property owners must meet specific criteria to claim it.
• 1031 Exchange to Avoid Recapture Tax: Property owners can defer depreciation recapture and capital gains tax by reinvesting proceeds into a like-kind property under a 1031 Exchange.

As a landlord, understanding depreciation and property value is key to maximizing your investment. Just like any asset, your rental property loses value over time, but the good news is, the IRS gives you a tax break for it.

In this guide, our team at SGI Property Management Phoenix will break down how depreciation works, how it impacts your property's value, and how you can use it to your advantage when managing your rental business.

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What is Rental Property Depreciation?

Over time, properties decline in value and this is termed as depreciation. The IRS understands this and allows deduction on the value your property loses over time as you rent it out and perform maintenance. 

In addition, properties can also be subjected to economic depreciation when external events like a real estate market downturn leads to the property’s decrease in value when tax season comes around.

How Does Rental Property Depreciation Work?

When you buy a rental property, it’s considered a big investment. To help offset the cost, the IRS allows you to deduct the property’s depreciation over time. Instead of claiming the full deduction all at once, you can spread it out.

For rental properties, you can claim depreciation each year for 27.5 years. If you use the property for business or farming for over a year, you can spread the deduction out for an even longer period.

What is the Depreciation Recovery Period?

The depreciation recovery period refers to how long you can claim depreciation on an asset. For real estate, this period is much longer compared to other types of assets. 

While items like office furniture and equipment are depreciated over 7 years, residential properties are depreciated over 27.5 years. Commercial properties, on the other hand, have an even longer recovery period of 39 years.

How to Calculate the Annual Depreciation?

To calculate your annual depreciation, divide the cost of your property (minus the land value) by its recovery period. This is different from calculating cash flow. Remember that while the building is depreciable, the land doesn’t lose value over time. 

The building itself is an asset that has a useful life. You can claim depreciation each year until the property is sold or the total cost basis is fully depreciated.

What Are the Tax Issues?

Investing in rental property can be a smart financial strategy, offering both a steady income stream and the potential for long-term appreciation. In addition to these benefits, rental property owners also enjoy various tax perks.

For instance, many of your rental-related expenses, such as mortgage insurance, property taxes, repairs, insurance, professional services, and travel for property management, are deductible in the year they are incurred, reducing your overall tax burden.

One of the most significant tax advantages is depreciation. Unlike other expenses that can be deducted in a single year, depreciation allows you to spread out the deduction of the property's purchase and improvement costs over its useful life. 

This makes it possible to claim a portion of the cost each year, rather than taking a large deduction upfront.

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How to Avoid Depreciation Recapture Tax?

You can usually claim your real estate investment property's annual depreciation as a yearly tax deduction, which helps reduce your taxable income. 

However, when you sell the property, the IRS may attempt to "recapture" the depreciation you’ve claimed over the years. This recapture tax is the difference between the property's sale price and its depreciated value.

The depreciation recapture tax on your rental property is typically capped at 25% of the amount you’ve depreciated, based on your standard rental income tax rate when you sell the property and make a profit.

The good news is you can avoid both recapture tax in a similar way as capital gains tax through a strategy called a 1031 Exchange. 

It is named after the relevant section of the U.S. Tax Code, which allows you to defer paying these taxes as long as you reinvest the proceeds from the sale of your current rental property into another similar property.

To qualify, the new property must be considered "like-kind" to the one you sold, and you must continue your rental business to generate taxable income. 

As long as you follow the rules and reinvest in a new property, you won’t owe recapture or capital gains tax until you eventually sell the new property. However, be aware that you must identify up to three potential replacement properties within 45 days of the sale, or you’ll forfeit the ability to use the 1031 Exchange.

What Are Some Special Considerations?

The amount of depreciation you can deduct each year depends on several factors, and it’s important to get it right. If you're unsure what qualifies for depreciation, consulting an accountant is highly recommended.

One key point to keep in mind is that the IRS doesn't let you use the full amount you paid for both the building and the land as your depreciation basis. Instead, you’ll need to separate the cost of the building from the land, as only the building is eligible for depreciation. 

Properly determining these values is crucial for maximizing your deductions and staying compliant with tax laws and increasing your ROI.

Who is Eligible to Claim Real Estate Depreciation?

To claim depreciation on your rental properties, make sure you meet the following criteria:

1. Ownership: You must own the property, whether outright or while paying off any debt, such as a mortgage.
2. Income-generating use: The property must be used in your business or for income-producing purposes, such as renting it out.
3. Determining useful life: The property must have a determinable useful life, meaning its value is expected to decline or depreciate over time.
4. Long-term use: The property must have a useful life of at least one year or more, ensuring that it will provide value over an extended period.

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Bottom Line

Claiming depreciation on your rental property lowers your tax bill each year, but it could lead to a depreciation recapture tax when you sell. While it saves money in the short term, carefully consider the long-term tax impact before deducting depreciation.

If you're confused or just need a guiding hand, get in touch with our team at SGI Property Management Phoenix! We'll help with everything from understanding depreciation to tenant screening and maintenance. Get started today and use our expertise to your advantage.