by Nick Gromicko, CMI®
One of the largest tax breaks for owners of investment property comes in the form of depreciation, or the loss in value of a property over time due to physical deterioration. The U.S. Internal Revenue Service (IRS) allows owners to take a tax loss every year based on this depreciation over the useful life of the asset, known as the cost-recovery period. This option can reduce their taxable income by thousands of dollars each year.
The plot of land on which the building rests, however, is not subject to depreciation because it is classified as a non-depreciable asset, or one that cannot lose value. This means that if an assessor values your total property at $300,000 and the land on which it sits is valued at $25,000, the property’s depreciable value starts at $275,000. The property can be devalued at a steady rate for a prescribed period of time, which, as of 2011, is 27½ years for residences and 39 years for commercial properties. In the same example, the property will depreciate at $10,000 per year until it has no value (on paper) 27½ years later. Even if the home’s assessed value has tripled during that time period, it is considered worthless to the IRS.
The catch, unfortunately, is that the depreciation amounts that you write off will reduce your original investment for the property, called the adjusted basis, thus increasing the taxable profit you must declare when you sell the property. For instance, if the owner of a property purchased for $250,000 took $200,000 in deductions by the time it was sold for $225,000, the owner would have to pay taxes on a $175,000 profit even though he took a loss on his investment. The IRS does not offer a “free lunch”; depreciation merely allows an investment property owner to pay for his meal long after he's eaten it.
Tips and Warnings for Owners of Investment Properties
- Owners should always claim the correct amount of depreciation each tax year because the IRS will assume it was taken. As a consequence, your adjusted basis in the property will be reduced in accordance with the tax credit you should have taken, even if you didn’t take it. Unclaimed depreciation may be accounted for in future tax returns, with certain limitations.
- Investment property does not begin depreciating upon its purchase or when the tenants actually take occupancy unless these dates coincide with the date that the property is rental-ready. For instance, suppose you purchase a property in April and make improvements until June, when you begin advertising it as a rental, but you are unable to sign tenants until August. According to the IRS, the depreciation period begins in June.
- Closing costs, such as inspection and appraisal fees, as well as other expenses associated with the original purchase of the house, count towards your adjusted basis in the property. Expenses incurred after the property has been rented, such as renovations and major improvements, are usually depreciated separately from the rest of the property's purchase price.
- Although you cannot depreciate land, you can depreciate landscaping and other land preparation costs incurred while preparing the land for business use.
- Your depreciation deduction for the first year is based on the mid-month convention, in which you can deduct only half of the first month’s depreciation. If you begin renting a property on July 3rd, you can deduct 5½ months of depreciation for the first year – not the full six months that the rental was operating.
- Check with the IRS to make sure that your property qualifies as depreciable property, as personal residences that are used for less than 50% business purposes may not qualify. IRS guidelines also explain other items that may be written off as depreciable losses, from common office equipment to exotic animals.
- Hire a qualified professional to assess the value of the property before its purchase. The IRS requires a detailed assessor’s estimate of the property’s value before you can begin claiming depreciation losses on your tax return.
- Always hire an InterNACHI inspector to examine an investment property for defects before it is purchased. Suppose the inspection reveals that one of the bedrooms in a three-bedroom townhome is non-conforming; you'll know in advance of the purchase that you cannot legally count on a third of your anticipated rental income without significant and costly modifications. InterNACHI inspectors are also trained to uncover an assortment of safety and system defects, from pest infestation to the presence of lead-based paint and mold.
In summary, depreciation is used by taxpayers to recover the cost of investment property. InterNACHI inspectors trained in residential and commercial property inspections can help streamline your purchase.