RENTAL DEPRECIATION
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Your rental property depreciation knowledge base
BASICS OF RENTAL PROPERTY DEPRECIATION
Most assets lose their value over time. Asset depreciation is an essential concept for any business or company. Depreciation significantly affects how you account for your tangible assets and how much tax you pay. This post will define depreciation, highlight its importance, and everything you need to know about calculating depreciation for rental property.
What is Depreciation?
Depreciation is a tool used to reduce the cost of a fixed asset throughout its useful life. Generally, the property owners allocate part of the cost to the period the asset assisted in generating sales or income. The decrease in value (depreciation) reduces the amount of tax you pay via tax deductions.
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Since depreciation reduces an organization’s earnings, the amount of tax a business or company owes is also reduced. The company or business claims tax depreciation expense to cover a tangible asset’s value reduction.
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You can start depreciating your assets as soon as you place them in use or when your property is ready to be rented. You can proceed to depreciate the asset until the entire cost of the property is deducted, or you dispose and retire the asset from service. This means that you can no longer depreciate your asset if you exchange, sell, abandon, convert it to personal use or if it is completely ruined.
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You can continue claiming depreciation expense if the asset is temporarily unused. For instance, if you own a rental property, you can claim depreciation expense to cover repair and maintenance costs or get the property ready for a new tenant. You can include depreciation in your tax returns since it is calculated at the end of each financial year.
Why is it Useful?
Depreciation allows companies and businesses to tax-write off the cost of assets over time. Besides, it can also help to track the use of an asset over a period and use the information to report the actual asset expenses for comparison with the asset purchase cost.
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Companies can easily compare the expenses incurred on the asset and the value it brings to the organization. Failing to depreciate your assets can lead to overstating asset values over the years. When assets are overstated, the records will be easily transferred to the financial books, thus generating inaccurate and misleading financial information.
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To enjoy the tax and other depreciation benefits, you need to maintain a copy of the asset’s invoice and proof that you paid the necessary sales tax for the asset.
What is Depreciable?
It is essential to note that you can only claim depreciation expenses from the tax authorities provided:
You own the tangible asset- Taxpayers can only claim depreciation expense for assets or property you own.
The asset is used to generate income- Depreciation expense reductions only apply for assets used in a business or another income-generating activity. This means that you can’t claim depreciation for assets dedicated for personal use.
The asset has a determinable useful life- The depreciating asset must have a useful life that can be determined or estimated. For instance, you can claim depreciation expense if you determine the duration your vehicle will remain active before it stops generating economic benefits or becomes obsolete.
The asset can last or is anticipated to last more than one year- Depreciation expense claims only apply to tangible long-term assets or assets with more than one year of useful life. It is essential to note that useful life is not the period an asset lasts but the duration an asset is expected to continue generating income or other economic benefits for the company.
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These factors do not apply to any property placed in service and cease to be useful or disposed of in the same year. Since land has an unlimited useful life, it is also not depreciable. It is also crucial to note that you cannot depreciate the cost of planting, clearing, and landscaping as they do not sum up the cost of the land.
A Simple Example of Calculating Depreciation for a Rental Property
The Internal Revenue Service (IRS) assumes that residential properties have an estimated useful life of 27.5 years and commercial properties have a determinable useful life of 39 years. For this reason, the annual depreciation expenses for residential and commercial properties are 3.636% and 2.564%, respectively.
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For example, if you own a residential rental property worth $325,000 that sits on an $80,000 parcel of land. To find the building value, you will need to subtract $80,000 from $325,000 to get $245,000. Then you can divide $245,000 (building value) by 27.5 to find the depreciation expense of $8,909 per year.
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$8,909 is the amount you will reduce on your taxable income without considering mortgage interest deductions and other property taxes.
Types of Depreciation Systems
Taxpayers use two standard depreciation systems- General Depreciation Systems (GDS) and Alternative Depreciation Systems (ADS). The system you pick will dictate the depreciation method to use and the recovery.
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The General Depreciation System entails using the declining balance as a depreciation method. The reducing balance method requires taxpayers to know the cost of assets, their expected useful life, the salvage value, and the depreciation rate. Typically the depreciation tax deductions in the asset’s first years of useful life are higher.
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The Alternative Depreciation System requires taxpayers to use a depreciation schedule with a more extended recovery period. If you choose to use the ADS, you should apply it to all assets of the same class placed in service the same year. It is essential to note that once you switch to the alternative depreciation system for a particular asset, you can’t switch to the general depreciation system.
Bottom Line
Depreciating assets allow property owners to reap tax benefits to cover the cost of maintaining an asset over its useful life. It is essential to note that tax depreciation is different from accounting depreciation, and companies must maintain separate records for the various types of depreciation. However, in most cases, the total amount of accounting depreciation and tax depreciation is the same over the useful life of the asset.