Unlike various investment options such as stocks and bonds, rental property is a depreciable asset. According to the IRS, depreciation is an “annual allowance for the wear and tear, deterioration, or obsolescence of the property.” It should be noted that this is only allowed for investment property and used for an income-producing activity. If you use any of it for personal uses, you can only deduct depreciation from the portion used for business.
Depreciation allows you to write off the cost of the property over time. Similarly, if you have any capital improvements, such as a major kitchen upgrade, these costs are also allocated over a period, rather than in the year it was done. This is opposed to other expenses such as general maintenance/repairs and HOA fees. For example, if you merely paint the kitchen, that is expensed immediately.
The first thing to know is that you cannot depreciate land. Therefore, you need to separate the cost of the land from the building. Second, for residential real estate, the IRS allows a useful life of 27.5 years. The IRS requires you to use the Modified Accelerated Cost Recovery System (MACRS) to depreciate residential real estate (assuming the property was put in service after 1986). Under MACRS, you can choose to depreciate the property under the straight-line method, which expenses the same amount annually, or under the General Depreciation System, which is more complicated.
Condos and co-ops
Living in New York City, you may choose to purchase condo or co-op units for rental. If you rent condo units, it becomes challenging since you own the airspace and the common elements, such as the land. If you have a property tax bill that separates the assessed value, you can divide the amount based on this allocation. Alternatively, you can use an independent appraisal or an insurer’s agent’s estimate. If there are special assessments charged for long-term improvements, you can depreciate the amount you paid.
For co-op rentals, you depreciate the stock owned by the corporation rather than the apartment (which you technically do not own).
Crunching the numbers
Presenting a simple numerical example should provide more clarity. You purchase a co-op and calculate the depreciable real property is $1.1 million. You may deduct $40,00straight-liner depreciation expense, assuming you utilize the straight-line method. This is the $1.1 million divided by 27.5 years.
You cannot have a passive loss in a year (there is an exception if you are an active participant subject to an income limit). However, if you have $50,000 left over when subtracting your other expenses from your rental income, this leaves $10,000 of taxable income. Your tax savings amount to the annual depreciation multiplied by your marginal tax rate. Assuming you are in the 28% income tax bracket, you saved $11,200 in your taxes for the year.
We have seen how utilizing depreciation, a non-cash expense improves your yearly cash flow. However, we noted this merely defers your taxes. When you sell your property, assuming it has appreciated, you are subject to a capital gains tax. In figuring this amount, the depreciation is “recaptured.” If you have a cumulative depreciation of $400,000, you owe a depreciation recapture tax at a 25% rate, or $100,000 ($400,000 times 25%). However, capital gains tax rates are currently lower than those for ordinary income, and there are ways to defer taxes on both capital gains and depreciation recapture taxes, such as a 1031 tax exchange.