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Depreciation De-Mystified: An Introduction to Rental Property Depreciation

Dollar Bill Origami of a HouseThere are many financial benefits of investing in rental properties. Some come during tax time when investors get to deduct operating expenses, property taxes, and so on. But on top of all these benefits, investors also get to deduct depreciation. This key tax deduction works differently from the others because of the unique way it’s calculated and applied. Also, failing to take a deduction for depreciation can lead to some problems later on. This is the reason why it’s important for El Segundo rental property owners to know what depreciation is and why you should be deducting it from your taxes every year.

In terms of buying and improving rental properties, depreciation is the process used to deduct any associated costs. Rather than take one large deduction in the year the property was purchased or improved, the IRS suggests that rental owners break the amount and spread those kinds of deductions over the useful life of the property. So basically, owners will not have one huge deduction but would be deducting a portion of their purchase and improvement costs (not operating or maintenance costs) each year for several years. This could dramatically reduce the amount you report as your taxable rental income. The huge effect this has on your tax return makes depreciation well worth the time it takes to calculate.

Property owners may begin taking depreciation deductions as soon as the rental property is placed in service, or in essence: ready to be used as a rental. That is certainly good news for property owners who have a vacancy right after buying the home or during renovations. The amount of years that you’d take the depreciation is set by two things. The first one is how long you own and use the property as a rental, and the second one is which depreciation method you use.

There are different depreciation methods that would result in different figures. You can use whichever method to determine the amount you can deduct each year. But the most common one for residential rental properties is the Modified Accelerated Cost Recovery System (MACRS). Usually, MACRS is used for any residential rental property placed in service after 1986. By using this method, the expense of buying and improving a rental property is spread out over 27.5 years, which is what the IRS considers to be the “useful life” of a rental house.

To determine how much depreciation you can claim each year, you’ll need to have your basis in the property or the amount you paid for it. You may also be able to include some of your settlement fees, legal fees, title insurance, and other costs paid at the settlement. This number is a bit complicated since there is a need to separate the cost of the land from the building since only the rental house itself – and not the land it is built on – can be depreciated. Usually, you can use property tax values to calculate what amount of the purchase price should be designated for the house, or your accountant might elect to use a standard percentage.

Once you’ve figured out the amount just for the rental house, you’ll need to take a step further and figure out your adjusted basis. A basis in a rental property could be adjusted to account for things like major improvements or additions, money spent restoring extensive damage, or the cost of connecting the property to local utility service providers. The basis may likewise decrease in the event of insurance payments you received to cover theft or damage and any casualty losses you took a deduction for already that were not covered by your insurance. Beginning with your adjusted basis, you can now calculate the amount of depreciation you can deduct on your income tax return.

Depreciation of a rental property is a valuable tool for investors looking to reduce their annual tax obligation. But things are more complicated since rental property tax laws can be complex and change quite a bit now and then. Since this is the case, it’s best to work with a qualified tax accountant to ensure that depreciation is being calculated and applied correctly.

When you avail of the services of Real Property Management California Coast, we can get you in touch with accounting professionals who can address your depreciation questions and more. Our experts can help property owners make sure that you are prepared and there are no unpleasant surprises at tax time. Please contact us online or call us at 310-535-2150 to learn more about how our El Segundo property management services can serve you.

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