Rental Property Depreciation: Rules, Schedule & Recapture

Cody Cromwell
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How Residential Rental Property Depreciation Works

When it comes to commercial property, there are several factors that can influence the property’s depreciation. Commercial property is generally depreciated over worthier periods (usually out 10-year mostly), while residential properties are depreciated over shorter time periods (usually over 2 to 5 years).

What makes this deprecation different from Home owner allowance depreciation is that you are only allowed to deduct the expenses that are directly related to and necessary to use and manage a rental property.

If you can show that the spending doesn’t contribute to operating expenses, they can’t be deducted. Looking at a few of the commonly applicable expenses, not only are they harder to prove, but going back every year to ask for a ride will drive you to insanity (well, at least temporarily ). Here are some that are harder to take:

Annual Property Taxes: They are deducted only if you pay them for the year you own the property and you don’t get a refund of taxes paid in the year in which you gained possession or settled the property. If you paid taxes for 2007 and 2008 and you moved in July 2008, you can only deduct the sum paid in 2007.

Did You Pay Friends or Relatives for Rental Related Services: People who help you manage your rental property can’t be deducted as an expense.

What Properties Are Depreciable?

These days, many major credit card companies will give you a line of credit that you’re only required to pay back. These lines of credit also have flexible terms that allow you to make minimum payments and rack up interest, while avoiding having to pay the upfront credit card charges.

Although credit cards are easy to obtain, they can be very expensive when you start to accumulate the fees for late payments, over-limit fees, and penalty interest. For that reason, it’s much more prudent to borrow against your home through a line of credit than it is to pay back a credit card.

Real estate owners use their personal homes as collateral in order to borrow against the equity in their collateral. When this line of credit is used to buy a new addition or remodel the house, then the value of the home will increase, which means the amount that the home owner can borrow will increase as well.

What’s the Catch?

Just because you’ve got a line of credit doesn’t mean you’ll get to live off of the interest. You still have to make your regular monthly payments, just like you do on a credit card, and the interest will only be calculated on the LTV (loan to value ratio) and not the value of the home.

Rental Property Depreciation Method

Rental property depreciation is a method used by rental property investors to calculate the decrease in value of a rental property during the time it is owned by the investor. The concept of rental property depreciation, or depreciation method, is usually used by property investors who take depreciation of buildings and property for tax purposes. The purpose of on-tax depreciation is to remove the benefit of tax-exempt income from income.

RELATED: Rental Property Depreciation Policy

The rental property depreciation calculation takes the different expenses on a rental property and uses them to determine how much the value of the building will decrease throughout the years of ownership. This concept is used to calculate how much of the cost of the property should be deducted for the property owner to have a net income in the year it is sold.

The rental property depreciation method usually takes into account the two main categories of expenses: (1) taxes and (2) maintenance.

The rental property depreciation method will usually take into account the tax depreciation method, in which the tax depreciation method will calculate the decrease of the value of the property for the use of the depreciation deduction percentage on the annual income. The rental property depreciation method will also take into account the maintenance depreciation method, which will be used to calculate the decrease in value of the property for the use of the amount over the useful life.

Rental Property Depreciation Schedule

In today's financial climate rental property depreciation is important to any new rental unit to rental property owner.

Some of the items that affect the amount, type and schedule of the depreciation to be recorded will depend on a) ownership, b) location, c) size, d) age and e) condition, some of these items are;.

  • The type of lease, can a fixed term lease be replaced by a short term lease?
  • Come Into an active business, can it be standard lease terms or is it an assignment of lease with GST & PAYG
  • Date of substitution of the existing with GST & PAYG
  • Renovation or alteration of the building
  • Fixtures and fittings
  • Replacement value
  • Buildings outside or buildings inside premise
  • Year of construction

Rent vs Ownership

Renters are generally concerned with the wear and tear possessions or space which their rent centres on, the rent accountants are concerned with the depreciation of real estate or premises.

Reporting Depreciation of Rental Property

If you’re about to enter into a 1031 Exchange, it’s important to understand how the IRS defines rental property and its depreciation. Since the Internal Revenue Code does not define what constitutes rental property, this assigns a huge burden to the IRS to manage the allocation and classification of rental property expenses for purposes of tax reporting and taxability.

In order to accomplish this, the IRS has created a complex system of rules that describe how dividends paid to an exchange participant are to be allocated. The most important thing to remember is that the IRS allocates rental property expense based on a formula that you cannot change.

The following is a quick summary of the IRS' classification method for rental property expenses.

The rental property must be personal property.

All rental income must be reported on a Schedule E and Form 4255 is required to record those rental income.

Rental expenses are to be amortized over the estimated useful life of the rental property.

If you own more than one rental property, divide the total of the rental expenses on the Schedule E and Form 4255 between the different properties based on their aggregated depreciable lives.

If you are reporting depreciation for fewer than the entirety of the tax year, you must use IRS Form 4562.

Use a Schedule E to Record Income and Expenses

What are depreciation and recapture?

In real property, depreciation and recapture are two methods to record income and expenses on a tax return; depreciation is sometimes called a spread method and recapture is called a write-off method. Depreciation is a method of allocating expenses to real property assets over a period of time. It is not a deduction on the income tax return.

Simple depreciation rules are in Section 1250, labeled ‘General depreciation.’

Recapture is a method of tax planning in real property. Recapture law applies to real property in part because real property has an anticipated life beyond a life cycle. In the case of shorter-lived assets (such as automobiles), we offer immediate depreciation deductions upon purchase. However, not so with real property. For tenancies in common, one of the reasons the IRS limits the income pass-through tax exemption percentage to 50% is because of the desire to recapture all depreciation destroyed by the limitations on the pass-through deduction in these cases.

A Schedule E is used to record all income and expenses on a rental property. The schedule E summarizes depreciation, expenses and the recapture levels that apply. We track expenses by renting the property or maintaining it over a number of months.

Figure Out Your Net Gain or Net Loss

Comparing the total rental income to the total expenses incurred is the surest method of estimating the moves of your Rental Property. You can use this Net Gain or Net Loss to gauge whether your investment is gaining or losing. Usually the property is itself being depreciated (unless it is a brand new building and/or already in the rental business), so the more the property gains, the more profit you’re making.

The net gain is accumulated in the Permanent Rental Asset Account and Form 4797 is used to compute the form. As soon as you notice a net gain – you must immediately pay an additional tax of 10%.

Additionally, you can choose to recapture the entire amount of your net gain at any time. But it has to be done within the year of the property’s sale (if you are planning to sell) otherwise the entire remainder is considered a long term gain and allowed to compound over a period of 5 years or more.

Depreciate the Purchase of the Property

Depending on income limits, some state and local government rebate a portion of homeowner association (HOA) fees for the use of HOAs in the purchase of the home you intend to occupy. In fact, many states have laws that limit the amount of HOA fees that may be used for the purchase of the home.

To qualify for the state or local government rebate, you must meet certain requirements including the area’s dwelling limit, which is the maximum allowed number of dwelling units allowed in the area.

The appraised value of the home is generally less than the actual value which is either determined by an appraisal or based on the sales comparison of similar homes in the area or city.

You are allowed to gain the entire rebate just by buying a first-time home. However, if you are purchasing a second or a third home, you will receive the entire rebate after the first year that you move in or lease the home.

One of the disadvantages of home buying through an HOA is that you may not have the flexibility to sell your home in the near future if you decide that you no longer like your neighborhood or home.

At the same time, some HOA systems allow you to terminate the contract after notice which is usually their lease.

Rental Property Depreciation Recapture

If you deduct certain property related expenses for tax purposes you are allowed to recoup those expenses through the depreciation of the related property. Every type of expense you can deduct directly from your gross income, as ordinary and necessary necessary and directly related to earning the income. The depreciation deduction may exceed the expense by as much as 50%. Now the good and bad news is in the form of a recapture of depreciation.

In determining if a expense is deductible, you must first determine whether it is ordinary and necessary. Ordinary expenditures are those that are both helpful and appropriate to the operation of your business. Collectively, they are your ordinary management of the affairs of your business. Necessary expenses are those that are helpful to the operation of your business and appropriate to earning the income. You cannot take a loss on ordinary and necessary expenses if you have a gain on a capital asset that you purchase with the money you use to pay the expense. Therefore, all the expenses must relate to your business while the profits must relate to your capital.

The rules relating to depreciation are different for real property, personal property and intangible property. You can depreciate certain property regardless of whether you actually use the property in your business. For instance take a used office van that you use for trade shows or home to work and you must wear it out, though it is a used car, you can still depreciate it.

Residential Rental Property Depreciation Recapture Example

Residential rental property is a common investment for many investors. The tax advantages of renting out a home mean that it can be a great stash for retirement or a means to build wealth for a family. But before a rental property investment is set in stone down payment must be secured and a proper budgeting and financial analysis must be completed.

The rental property deduction available to most taxpayers is dependent on two factors. The gross income from the rental property and the amount of rental expenses. Special rules that limit this deduction are imposed should the taxpayer recognize a taxable event during the year. Typically, a taxable event takes place when there is a change in accounting method. This can happen when a property is sold, exchanged, or disposed of.

This blog post will go over how tax depreciation works for residential rental property, when recapture occurs, what the recapture schedule is, and how it is handled on the tax return.

Depreciation of Rental Property Frequently Asked Questions (FAQs)

Find out more about the subject of Rental Property Depreciation, its basics, as well as the rules and procedures.

Renting out a rental property has certain advantages. You can:

  • Make money to pay for new rental property you may want to purchase in the near future
  • Receive tax breaks that may help with your income taxes (home office deduction, mortgage interest deduction)
  • Schedule your rental income (rental property depreciation) so that you can deduct the expenses associated with the rental property, resulting in savings on your personal income taxes (Schedule E on IRS Form 1040, Schedule C on IRS Form 1040)
  • Buffet up your financial wealth by lowering your income taxes and increase the value of the rental property in the future
  • Eventually make money in the residual value of the rental property (through depreciation or loan payments)

In addition, renting to only a select group of people or lease terms are a method of advertising in a way that no other method can do. However, the advantage of renting a property has some disadvantages also. Among these disadvantages are:

You can lose money, due to bad tenants or a decline in rental value

What Depreciation Method Is Used for Rental Property?

Whether you are a landlord or a tenant, it is important to understand the depreciation method used on your rental property. The type of depreciation method determines your deductions, tax reporting, and annual tax return filing. The different methods used are as follows:

  • Straight Line Depreciation
  • Cost Accounting
  • Double Declining Balance Method
  • Depreciation Method of Original Basis
  • Mixed Depreciation Methods
  • Loss Carryforward

The straight line depreciation method, which is the most popular method, applies to all assets. This is used to calculate depreciation for your rental property. However, the U.S. and Canadian tax authorities use different methods to value rental income. The methods used by the Internal Revenue Service (IRS) are explained below.

With the straight line method, you deduct a constant amount each year for depreciation on your rental property. depreciation start at a specified rate based on the property’s useful life, and then decreases at a constant rate each year.

For example, the rate to be used is the MACRS, which stands for Modified Accelerated Cost Recovery System, and is the depreciation method used by the IRS. The MACRS is calculated annually for each year after 1978. According to the IRS, the MACRS rate to be used during the year 2013 would be 9% and after 2013 39.6%.

What Happens to Real Estate Depreciation When You Sell the Property?

Is it All Gone?

Yes … and No, Depreciation will be Taxed!

Real estate investments are the envy of many investors and homebuyers. In this article, we highlight the key terms for depreciation that you need to know, including the difference between Depreciation and Amortization.

When you purchase a rental property, there could be several other expenses that come along with it besides the monthly mortgage and taxes that are deducted. These include Underwriting Fees, Applicant Fee, Buyer’s Inspection, Closing Costs, etc. You may even have Club Fees, a Professional Management Service and a Maintenance Fee to cover the costs associated with your rental property. In addition to all these, your property will also harbor additional expenses such as a Property Tax. The margins of income in owning a rental property typically increases as the property increases in value. However, the costs to own the property also show up in the form of expenses, and that is where depreciation comes in. All of these expenses are amortized over the life of the property, and are lumped into the month-to-month expenses of operating the property. Once the property is sold, the deprecation will also be taxed.

The depreciation rules and schedule are set by the IRS and vary from year to year and property type. Here is a look at what you can expect for both residential and commercial properties.

Do You Have to Take Real Estate Depreciation?

In every state the property you rent is depreciable, meaning you can deduct a part of the cost of the property from your taxes. Most of us consider an apartment complex to be a single rental property, but this is not the case. Individuals who own property and rent it to boarders fall into this category. You also have to consider whether you suffer personal liability in the case of lawsuit or crime. The answer is YES.

You have to report all items that form part of the rental property (from bedsheets to fixtures, building and equipment, fixtures and furniture, vehicles, and everything else that cost less than the fair market value, which is listed as the original cost of the property less depreciation taken.)

Depreciation figures come from two different sources: IRS7 and IRS3. IRS7 gives the total depreciation allowed for each property class (residential vs. commercial) as well as rental tax classification based on the RAT. RAT is the rent at which the property is marketed, classified using the Tax classification as Commercial, Industrial, or Residential.

The IRS3 schedules give the Depreciation Deduction based on the type of property, class of property, and rental tax classification.

The total present value depreciation deducted for the year is the cost of the property (don’t forget the seller’s commissions) less the depreciation taken.

The Bottom Line

Rental property depreciation can be a tricky thing to value because several factors come into play (the location, the condition of the property, etc.)

Not surprisingly, however, you must be able to depreciate the property – and taxes are one of the factors that will impact its value. This depreciation is one of the determinants in the property’s IRS Tax Schedule, Form 1040, and it’s especially important to value rental property for depreciation purposes.

According to IRS rules, rental property depreciation starts at the time you first begin using the property to generate rental income. It usually ends 14 years later, the year that you stop using the property for rental purposes.

Most importantly, if you’ve stopped being a landlord, you must attach a Form 6198 to your tax return for the last year you owned the property. Form 6198 has two purposes: (1) to request you to report your rental income, and (2) to calculate the amount of depreciation you’ve taken since you stopped being a landlord.