What is depreciation?
Depreciation is an important tool for rental property owners. It’s a way for rental property owners to recover the cost of their income-producing properties and associated assets by deducting a portion of the cost each year on their tax returns, thereby lowering their tax liability. Most investors have a general awareness of depreciation as it applies to buildings, but not everyone understands that smaller assets and improvements qualify for depreciation as well. Because depreciation affects your taxes, it’s important to understand what types of property qualify for depreciation, when the deductions may start and end, which methods can be used to calculate the deduction, and how much of a deduction may be taken each year.
What rental property assets can be depreciated?
You may depreciate your asset if it meets all the following criteria:
- You own the asset.
Even if the asset is subject to a debt, such as a mortgage, as long as you are the owner of the asset, and you meet the other requirements, you can take the depreciation deduction on your tax return.
- The asset is used for an income-producing activity.
Keep in mind that you can only deduct depreciation on the part of your property used for rental purposes, so if you rent out a single room of your home or only the storage shed in your backyard, you won’t be able to deduct depreciation on your entire property, only on the portion used to produce income.
- The asset has a determinable useful life.
For an asset to have a determinable useful life, it must be something that can decay, get used up, wear out, become outdated, or lose its value from natural causes. For example, land is not depreciable since it can’t become obsolete or get used up; however, the new roof you had installed on your rental unit is expected to last about twenty years—the roof has a determinable useful life, so it can be depreciated.
- The asset is expected to last for more than one year.
Even if all the other requirements are met, you may not depreciate property that is placed in service and disposed of in the same year.
With these criteria, your rental property’s structures, furniture, appliances, improvements, sprinkler systems, and even some landscaping are depreciable assets.
When does depreciation start and end?
Depreciation begins once you place your asset in service to produce income. According to IRS standards, the asset is placed in service when it is ready and available for use. Even if you aren’t using the asset, if it is ready and available for its specific use, it is considered in service. For example, if you ordered a new water heater for your rental unit in October, and it’s delivered in December, but it isn’t installed until January, then the in-service date would be the day it’s installed in January, not the purchase date in October.
If you purchased a property in May and need to make repairs to the house before putting it up for rent, the property won’t be considered in service until the repairs are complete and the house is ready for tenants. If the house is ready and available to rent in August, then the in-service date is the day you list the house for rent, even if you don’t have a tenant lined up yet.
Although you can’t depreciate personal assets, if you convert the asset to business use, you may begin to depreciate it on the date of the change. So if you used a house as your personal home for several years, but you then converted it to a rental property, the in-service date would be the day you took possession of the property. However, you couldn’t claim depreciation until the year you converted it to a rental property.
Even if your rental unit is temporarily idle, you may continue to claim depreciation. If you need to make repairs after a tenant moves out, or if you have a gap between tenants, you would still depreciate the unit while it isn’t in use.
Depreciation stops once you have recovered your cost basis or when you retire the asset from service, whichever happens first. For the cost basis to be fully recovered, the total of your annual depreciation deductions must equal the cost or basis of your asset. When you retire an asset from service, you permanently remove it from use in business by one of these means:
- You exchange or sell the asset.
- You convert the asset to personal use.
- You abandon the asset.
- The asset is destroyed.
Once the asset is retired from service, depreciation for that asset ends, even if the cost has not been fully recovered yet.
Which method should I use to calculate depreciation?
There are multiple methods for calculating depreciation, so current investors must be aware of the two most common depreciation systems, plus property classes, recovery periods, and conventions. Your asset’s in-service date helps determine which method you should use to depreciate it. For assets placed in service after 1986, you generally must use the Modified Accelerated Cost Recovery System (MACRS) for residential rental properties. If your asset was placed in service before 1987, see IRS Publication 534 for the applicable depreciation information.
MACRS
MACRS has two systems that determine how you depreciate your assets: the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). If you choose to use ADS, the decision must be made in the first year the asset is put in service, and your rental property must meet certain criteria. However, most assets placed in service use GDS.
GDS Property Classes
With MACRS, all assets that can be depreciated are assigned a property class, which is determined by its class life. The class life usually governs the depreciation method, recovery period, and convention, all of which affect your annual deduction amount.
The GDS property classes commonly used for real estate are
- 5-year property,
- 7-year property,
- 15-year property, and
- residential rental property.
Items like appliances, carpeting, or furniture for residential rental properties generally fall into the 5-year property class, along with computers, office machinery, and cars for businesses. Office furniture, such as desks and file cabinets, is part of the 7-year property class. Assets, like fences, roads, driveways, or foundation shrubbery, that are improvements added to or made directly to land fall into the 15-year property class. The residential rental property class covers buildings or structures but also includes structural components like furnaces, venting, plumbing, etc. For more information on property classes, see IRS Publication 527.
GDS Recovery Periods
An asset’s recovery period is the number of years over which you recover its cost or basis. GDS typically has shorter recovery periods than ADS. The item’s property class determines its recovery period, and with GDS, the property class is usually the same as its recovery period.
Any additions or improvements made to your rental property should be treated as separate items for depreciation purposes. The recovery period for an addition or improvement begins on either (1) the date the addition or improvement was placed in service or (2) the date the original property was placed in service, whichever is later. So if you renovate the kitchen of your rental property, the recovery period begins once the renovation is complete and in service because it occurs at the later date.
Conventions
A convention is a method used to set the beginning and end of the recovery period. Which convention you use will determine the number of months that you can claim depreciation in the year the property is placed in service and the year when the property is disposed. The three convention options under MACRS are mid-month, mid-quarter, and half-year. Most residential rental properties use the mid-month convention.
Calculating Depreciation
Three key factors determine how much depreciation you may deduct each year: (1) your basis in the property, (2) the recovery period for the property, and (3) the depreciation method used. We recommend that you work with a qualified tax accountant on calculating your depreciation, but we’ll cover the basic steps as an overview.
Step 1: Determine the basis of the asset.
The property basis is the cost or amount you paid to acquire the asset. For improvements such as a kitchen remodel or the addition of a new paved driveway, you would use the total cost of the renovation or addition as the basis. If you replaced the furniture in your furnished rental, the amount you paid for the new furnishings is the basis. For more information on calculating the basis for your rental’s land and buildings, see our related article on journal entries for closing statements. Remember, land does not qualify for depreciation, so you must separate the cost of the land and buildings before calculating depreciation.
Step 2: Calculate depreciation for your asset.
Once you know the basis of your property and have determined which depreciation method applies to you, you can calculate your MACRS depreciation using one of two ways:
- the percentage from the MACRS percentage tables or
- the depreciation method and convention that apply over the recovery period of the property.
If you would rather compute the deduction, see chapter 4 of IRS Publication 946. For the complete percentage tables, see Appendix A of Publication 946.
Step 3: Record and report your asset’s depreciation.
After you’ve calculated your asset’s depreciation, record it in your account books. REI Hub has Knowledge Base articles with step-by-step instructions on how to enter depreciation. And because the depreciation deduction counts as an expense for your property, you’ll report it on your Schedule E when you file your taxes. The net gain or loss is then recorded on your Form 1040.
Benefits of Depreciation
Depreciation is an important way to reclaim the costs of your rental property assets, and it provides long-term tax benefits. That’s why REI Hub includes a reminder to check your depreciation figures as part of our Tax Time Double-Check. Since depreciation is one of the expenses you’ll include on your Schedule E, it will help reduce your tax liability for the year. And because it’s not a one-time deduction, you’ll benefit from the depreciation deduction for the entire useful life of your asset, which can range from five to thirty years depending on the depreciation method you choose and the applicable property class. Whether you decide to track and calculate your asset’s depreciation yourself or work with your tax preparer on it, it’s worth the effort in order to claim the depreciation deduction for your property.
