RENTAL DEPRECIATION
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Your rental property depreciation knowledge base
DEPRECIATION SYSTEMS FOR RENTALS
Real estate depreciation is a powerful tool that enables rental property owners to keep more of their money in their pockets than paying it to the federal government in the form of tax. In fact, it’s one of the most important reasons many people choose to invest in real estate in the first place.
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Depreciation allows rental property owners to deduct the costs from their taxes of buying, modifying, and developing a property over its useful life to reduce their taxable income.
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In this article, we’ll discuss everything you need to know about depreciation and provide more details on the two common depreciation systems: General Depreciation System (GDS) and Alternative Depreciation System (ADS).
What is Depreciation?
Property depreciation is the reduction in the value of a property over time due to normal wear and tear. It is a basic accounting concept that effectively lets real estate investors deduct the cost of a property with a service life of twelve months or more over a long period.
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As such, depreciation can help provide tax benefits by providing a way to shift into a relatively lower tax bracket or eliminate any income tax expenses you might face. In simple terms, rental property depreciation allows investors to cut their income tax bills while maximizing their gains on any real estate asset.
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27.5 years is the recovery period – the duration in which rental property depreciation can be claimed. Generally, the government recognizes that a property can deteriorate and lose value over time. Thus, they believe that after that period elapses, the rental property will basically devalue.
Who Qualifies for a Rental Property Depreciation Claim?
Any investor who intends to claim depreciation in their rental assets must meet the following eligibility requirements:
An investor must be listed as the asset owner, either directly or as they pay off debt.
The said rental property must have a useful life that surpasses at least a year.
The rental property in question must be used for commercial purposes.
An investor must be able to determine their property’s useful life; this means that the property will devalue over time.
Rental Property Depreciation Systems
There are two major depreciation systems under Modified Accelerated Cost Recovery System (MACRS): General Depreciation System (GDS) and Alternative Depreciation System (ADS). The MACRS is the most popular tax depreciation method in the United States. It was created by the Internal Revenue Service (IRS) and is used for the depreciation of business assets obtained after 1986 for income tax purposes.
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The Modified Accelerated Cost Recovery System allows larger depreciation deductions in the initial years and reduces deductions in the following years of property ownership. The MACRS system allows for the deduction of depreciation using two techniques: the straight-line method and the declining method.
Depreciation & Taxes under MACRS
The MACRS requires taxpayers to calculate their tax deductions for the depreciation of physical assets using specified methods and useful lives. Under MACRS, assets are divided into categories based on the asset type and application. The two main subsets of MACRS are the general and alternative depreciation systems, as discussed below.
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Understanding General Depreciation System (GDS)
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The GDS is the most popularly used form of Modified Accelerated Cost Recovery System for calculating depreciation. The depreciation system employs the declining balance technique to depreciate real estate property.
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Under the general depreciation system, the depreciation rate is deployed against the non-depreciated balance. Unlike the alternative depreciation method, the general depreciation system uses shorter recovery durations.
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For example, if a rental property that costs $2,000 is depreciated at 30% each year, the tax deduction is $600 for the first year and $420 for the second year.
Understanding Alternative Depreciation System (ADS)
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An alternative depreciation system computes depreciation using a straight-line concept over an extended period of time. With the longer depreciation schedule, the property’s income streams can be better mirrored than in the GDS, which uses depleting balance depreciation.
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Generally, if you decide to use the ADS method, you must deploy it to all assets of the same category placed in service during the same period. As a real estate investor, knowing how to use the alternative depreciation system is important as it can help you accurately compute your depreciation expenses to lower property taxes.
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In most cases, ADS is used by small businesses with high growth rates but with limited taxable income. This system allows investors to evenly spread out the cost of tangible assets over a given number of years, often referred to as the useful life of the rental property.
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Useful life, in this case, is an estimate of the period a property is likely to remain in service to help generate revenue. Besides rental property, the ISR allows businesses to depreciate other forms of assets, such as manufacturing equipment, fixtures, automobiles, and computers.
The alternative depreciation system can be used in a variety of circumstances, including:
Any real estate property used 50 percent or less for commercial purposes
Some types of tax-exempt assets
Any physical property used outside the United States during the year
Farming equipment – under some conditions
General Depreciation System vs. Alternative Depreciation System
The GDS and ADS are both great systems for depreciating rental property under the MACRS. The general depreciation system allows investors to accelerate the rental property depreciation rate by providing a higher depreciation value for the early years of a property’s useful life, and the amount reduces in the subsequent years.
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This general system is the most commonly used depreciation method than the alternative depreciation method. And it is popularly used by businesses to depreciate assets that become obsolete quickly.
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On the other hand, ADS offers depreciation over an extended period of time using a straight-line method. Although this method stretches the number of years a property can be depreciated, it also significantly reduces the annual depreciation cost.
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The straight-line concept means that the depreciation value is scheduled at an equal amount for each year. Under the IRS guidelines, once an investor chooses to use the alternative depreciation method for a property, they cannot shift back to the general depreciation method.