Depreciation is a way to account for how buildings and property wear down over time. Think of it like how a car loses value as it gets older. For real estate investors, depreciation is important because it lets them reduce their taxes by writing off part of their property's cost each year.
Types of Depreciation:
Straight-Line Depreciation
This is the simplest way to calculate depreciation. You take the cost of the property and divide it equally over a set number of years. For example, if you have a rental house that cost $200,000 (not counting the land), you would divide it over 27.5 years. This means you can deduct about $7,273 each year from your taxes.
Accelerated Depreciation
This method lets you deduct more money in the early years of owning a property and less in later years. It's like front-loading your tax savings. This can be helpful if you want bigger tax breaks now instead of spreading them out evenly.
MACRS Depreciation
MACRS (Modified Accelerated Cost Recovery System) is the standard system used in the United States for depreciation. Think of it as the rulebook that tells you how long you can depreciate different types of property.
There are two main types of MACRS:
1. General Depreciation System (GDS)
This is the most common system used by real estate investors
Residential rental properties are depreciated over 27.5 years
Commercial properties are depreciated over 39 years
Most investors use this system unless they're required to use ADS
2. Alternative Depreciation System (ADS)
This system usually spreads depreciation over a longer time period
Residential rental properties are depreciated over 30 years
Used when properties are primarily used outside the United States
Required for some types of tax-exempt use properties
Bonus Depreciation
This is like a special offer from the IRS that lets you deduct a large percentage of certain property improvements right away, instead of spreading them out over many years.
Bonus Depreciation applies to things like:
New appliances
Carpet and flooring
Roofs
HVAC systems
Kitchen cabinets
Important Terms to Know
Cost Basis
The total amount you paid* for your property, including:
Purchase price
Closing costs
Major improvements
Legal fees
*Note: Land value must be subtracted because land cannot be depreciated.
Useful Life
How long the IRS says you can depreciate different types of property:
Residential rental property: 27.5 years
Commercial property: 39 years
Appliances and carpeting: 5-7 years
Fences and driveways: 15 years
Placed in Service Date
This is when you start using your property as a rental. It's important because depreciation starts on this date, not when you bought the property.
Common Mistakes to Avoid
Trying to depreciate land (only buildings can be depreciated)
Not keeping good records of improvements
Forgetting to separate personal use from business use
Not starting depreciation on time (you can't wait to start it when it's more convenient)
When Depreciation Ends
Depreciation stops when:
You sell the property
You convert it to personal use
You've deducted the entire cost basis
The property is destroyed or condemned
Tax Impact
Remember that when you sell your property, you might have to pay back some of the depreciation benefits you received. This is called "depreciation recapture" and is typically taxed at 25%.
Depreciation Tips for Investors
Keep detailed records of all improvements
Consider consulting with a tax professional
Take photos of improvements for your records
Track all expenses related to your property
Understand what can and cannot be depreciated
Find a qualified a cost segregation specialist to learn more about accelerated depreciation or reach out to your CPA to optimize your depreciation strategy.
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