Calculate Depreciation on Rental Property

How to Calculate Depreciation on Rental Property

Understanding Depreciation Methods

Depreciation for rental properties allows property owners to deduct the cost of the property over its useful life. After a property is placed into service, depreciation begins and continues until the owner has fully recovered their cost or ceases to use the property for income production. The most common system used is the Modified Accelerated Cost Recovery System (MACRS).

Choosing the Correct System

For residential rental properties placed in service after 1986, the MACRS system applies, utilizing the General Depreciation System (GDS) in most cases. Under GDS, residential rental properties depreciate over 27.5 years, and nonresidential real properties over 30 years. Only in specific situations is the Alternative Depreciation System (ADS) used, such as for nonresidential real properties or properties held by electing farming businesses.

Determining the Depreciation Percentage

Calculate the annual depreciation using the GDS recovery period. The percentage is adjusted if the property was in service for less than a year, based on the month it was put into service. For each subsequent month beyond the first year, the depreciation percentage is approximately 3.636%.

Utilization of Calculation Tools

To simplify the process, use an online rental property depreciation calculator. These tools provide detailed breakdowns of depreciation schedules, compute the total depreciation claimable, and estimate potential tax savings.

Conclusion

Accurate depreciation calculation is crucial for maximizing tax benefits. By selecting the appropriate depreciation system and accurately determining the depreciation schedule, property owners can effectively manage their investment's financial health.

How to Calculate Depreciation on Rental Property

Understanding Depreciation

Depreciation is a significant non-cash tax deduction that reflects the loss in value of a rental property over time. It allows property owners to reduce their taxable net income by accounting for the natural wear and tear of the property.

Determining the Cost Basis

To start the depreciation process, calculate the cost basis of your rental property. This is done by adding the purchase price to any closing costs and subtracting the value of the land (as land is not depreciable). The formula is: Cost Basis = Purchase Price + Closing Costs - Land Value.

Choosing the Right Depreciation System

For most residential rental properties, the General Depreciation System (GDS) is appropriate and uses a recovery period of 27.5 years. The Alternative Depreciation System (ADS) is used for certain types of properties or under specific circumstances demanded by the IRS.

Applying the Depreciation Formula

Under the straight line method, which is synonymous with ADS and commonly used in GDS, annual depreciation is calculated by dividing the cost basis by the recovery period. The formula is: Annual Depreciation Expense = Cost Basis / 27.5. For partial years, adjust the first year's depreciation according to the month the property was placed in service.

Example Calculation

For a property purchased at $391,000 with land valued at $91,000 and no additional closing costs, the cost basis is $300,000. Using GDS (27.5 years), the annual depreciation would be approximately $10,909 (300,000 / 27.5).

Calculating Depreciation on Rental Property: Practical Examples

Example 1: Straight-Line Depreciation Method

The Straight-Line method is commonly used for its simplicity. To calculate depreciation, divide the property's cost by its useful life. For instance, if a rental property is purchased for $200,000 and has an estimated life of 27.5 years, the annual depreciation expense is calculated as $200,000 ÷ 27.5 = $7,272.73 per year.

Example 2: Modified Accelerated Cost Recovery System (MACRS)

Under the MACRS, which is mandated by the IRS for residential rental properties placed in service after 1986, the property depreciates over 27.5 years using a specific declining balance method. If a property with a cost base of $220,000 (excluding land) falls under this category, its first-year depreciation could be roughly $8,000, calculated based on IRS depreciation tables.

Example 3: Depreciation with Land Value Consideration

For accurate depreciation calculations, exclude the land’s cost as land does not depreciate. If a rental property is bought for $300,000 with land valued at $100,000, only the building value, $200,000, is depreciable over 27.5 years. Thus, annual depreciation is $200,000 ÷ 27.5 = $7,272.73.

Example 4: Mid-Year Convention

The IRS implements the Mid-Year Convention, which assumes all properties are in service for half the year upon acquisition. If a property is hub for $250,000 (excluding land) in June, the first year’s depreciation would be half of the typical annual depreciation—hence, $4,545.45 for that first year ($250,000 ÷ 27.5 ÷ 2).

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