Many landlords know that they can claim rental property expenses like insurance on their federal tax returns. However, one of the biggest rental income deductions is depreciation. Depreciation is a simple concept: objects (in this case buildings) become less valuable over time. The IRS allows landlords to claim depreciation over time to offset the rental income landlords should make on the property.
Claiming Depreciation on Your Federal Taxes
On Schedule E, landlords need to disclose their rental income and any expenses. One of the largest possible expenses on this form is depreciation. When claiming depreciation on a rental property, it's important to use only the value of the structure on the property and not the land value of the property. The IRS states that landlords can claim a useful value of a house for 27 years and 6 months.
Here's how the numbers work in a simple tax scenario. Say a landlord buys a property for $250,000 to use as a rental. Using the tax assessor's evaluation, the landlord knows that the land has a value of $75,000, which means that the structure has a value of $175,000. The landlord divides that number by 27.5, for approximately $6,364 in depreciation that can be claimed on Schedule E.
Depreciation should also be claimed on certain rental property improvements, which decrease in value as time passes. For example, a landlord who paid $25,000 for a new roof on a rental property can claim depreciation during the expected useful life of the roof. If the roof has a useful life of 20 years, the landlord can claim $1,250 depreciation each year for the next 20 years.
Filing Taxes After the Sale of a Rental Property
When a landlord sells a rental property, he or she might find that the property did not depreciate. In that case, the landlord has a tax obligation to the IRS for that year's taxes. The IRS charges a 25 percent depreciation recapture rate of any financial gain the landlord made during the sale of the property.
Remember the $250,000 property purchased earlier? Let's say that after 10 years and approximately $63,640 in claimed depreciation, the landlord sells the rental property for $350,000. The value of the land hasn't increased, so the landlord has two tax liabilities on the sale. The first tax liability is a capital gain of $100,000 on the overall sale of the property. The second tax liability is the depreciation that didn't occur in the amount of $63,640. The IRS charges a flat 25 percent tax rate on that $63,640, which would be $15,910.
Why Claiming Depreciation Is Still Important
Without knowing if a rental property will depreciate, landlords might be tempted to not claim depreciation on their Schedule E. However, claiming depreciation is a sound financial move. A flat tax rate of 25 percent is similar to the taxes the landlord would have to pay anyway on the financial gains on the property. Plus, the IRS charges a depreciation recapture rate despite whether depreciation was claimed on Schedule E. One of the best ways to avoid paying this recapture rate is to reinvest the proceeds of the sale into the purchase of another rental property.
Depreciation is a common rental property expense that should be deducted under most circumstances. Accountants and tax preparers should know about these deductions, but landlords filing their own taxes might overlook this opportunity. Landlords should claim depreciation to reduce their yearly tax burden, but they should be prepared to pay a depreciation recapture rate when applicable.
Please note: These articles are for informational purposes and we advise you to consult your accountant for more specific information related to your situation.
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