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Subsequently, you must have heard that Real Estate is the real deal, thus, making you interested in getting a property. While this is true, it is also important to know certain factors or tools to aid in the management of your property. One such tool is Real Estate Depreciation, and every property owner needs to know exactly what it means, how it works, and how to calculate it. Find out more in this article below.
Real Estate Depreciation (or Rental Property Depreciation) is a situation that involves cost deduction from taxes of buying or improving a property. It simply means removing the purchase price and the cost of improvements from a building's tax returns. It allows you to do this over the property's useful life, reducing annual taxable income.
This depreciation is a better alternative to the regular deduction from buying or improving a property that mostly incurs a huge loss. In summary, this method can deduct rental expenses such as property taxes, mortgage insurance, repair and maintenance expenses, etc., throughout the property's life instead of doing it once.
Generally, real estate is a great financial investment but also requires being smart about it. If you are considering Real Estate Depreciation, you should know that the Internal Revenue Service (IRS) has some requirements or conditions for a rental property to depreciate. See below.
Additionally, you should know that the building's value can only depreciate – the land cannot.
If you meet these criteria for rental property depreciation, the next thing to know is when it begins.
Depreciation starts when the property is placed in active service or ready for rental use. It doesn't begin when your first tenant pays rent or moves in.
More importantly, a property would only remain depreciated until you meet any of the requirements below:
Meeting the requirements is one thing; discovering the factors to calculate real estate depreciation is another. Three significant factors are considered: the property's basis, the period of recovery, and the depreciation technique.
You might need a tax accountant on this for an accurate depreciation value. But notwithstanding, here is how to calculate:
By Basis, it means the actual payment for an acquired property. It could be in cash, mortgage, or in other kinds. It also often contains certain settlement and closing fees such as legal fees, title insurance, recording fees, surveys, etc. However, others like fire insurance premiums, rent and loan charges, appraisal fees, and mortgage insurance premiums are excluded.
As aforementioned, only the cost of the property can be depreciated, not the land. Therefore, you need to differentiate both costs by determining their independent values. A fair market value strategy can be used for the property's cost.
With the value of the house and the basis of the property known, the house basis is next. It basically means the actual amount that can be depreciated.
The last step is determining the final value by increasing or decreasing the basis of your property. Before you can do this, however, consider some conditions around the time of property purchase and rental.
Based on the Deduction Technique, there are two types – General Depreciation System (GDS) and the Alternative Depreciation System (ADS). The former works for general purposes, i.e., rental property in service, while ADS only works for agriculture and tax-exempt situations.
Understanding Depreciation is important for every real estate property owner. It helps you manage the cost of buying a property by spreading it over the years of useful life instead of taking huge deductions. And with this method, you get a lower tax bill and a tax gain when you sell a property beyond its depreciation value.
