How to Calculate Depreciation Expense for a Rental Property
We do a lot of tax returns for individuals whom have investments in real estate. Some have a single-family home that they previously owned and decided to rent out once they moved. Others have a duplex that they recently purchased to live in one half and rent out the other. Either way, by far the most common mistake made by those who attempt to do their own taxes (or even some tax preparers who may not have a background in accounting) is the failure to account for, or incorrectly report, depreciation expense.
Depreciation occurs when you purchase an asset, which is something that the IRS considers to have a useful life of greater than a year. Rather than deduct the entire amount you paid in the year of purchase, they want you to take annual deductions instead. It could be a computer (5 years) or a desk (7 years) used for business purposes. In this case, it could be a rental property, which is depreciated over 27.5 years (It should be 30 years, to mirror the length of the most common mortgage, but the IRS never makes anything easy on us).
The starting point for depreciation is, in most cases, the cost. So, if you paid $500,000 for a property that you intend to rent out immediately, then $500,000 is your starting point. But here’s where it gets tricky: the property you’re renting out is sitting on a piece of land. And guess what, land never depreciates. Only the building itself can be depreciated.
We then have to figure out how to split that $500,000 between the land (which doesn’t depreciate) and the building (which does). The easiest way to do so is to take a look at the most recent property tax assessment done by your town. Even though you paid $500,000, let’s assume the town values the property at $400,000. Out of that $400,000, they believe the land is worth $100,000 and the building is worth $300,000. They’ve allocated 25% ($100,000 of $400,000) to the land and 75% ($300,000 of $400,000) to the building. Once we’ve figured out the proper split between land and building, it’s finally time to come up with the correct starting point for depreciation. In this case, we’d multiply the price you paid ($500,000) by the percentage allocated to the building (75%) to come up with the correct amount of $375,000. The $375,000 will be depreciated over 27.5 years, or until you sell the property. That’s between $13,000-14,000 of depreciation expense each year to offset your rental income!
The example I’ve given is a rather straightforward one. Things can get rather complicated when you convert your primary residence to a rental unit or when you rent out only part of your home. But that’s why you hire us, right?