How To Calculate Depreciation On Rental Property
Real estate can be complicated, but once it is understood, it's not as complicated as it appears. This article is going to form an explanation of what real estate depreciation is, how depreciation works, and why you should care.
Why Is Depreciation Important
Why should you care about real estate depreciation? Depreciation may be the single most valuable tax deduction offered in America. That's a strong statement in light of all the other tax advantages in the tax code. But it may be true. To prove the point, many of the wealthy today have made their fortunes in real estate investing. Donald Trump, for example, is one of those individuals.
To summarize, depreciation is essential because any time taxes can get avoided, it means there's going to be more money kept by the investor....which no doubt increases return on investment.
How Does Real Estate Depreciation Work?
Before we learn how depreciation works, let's start with the basics. What does depreciation mean? Depreciation is the reduction in the value of an asset over time, mainly due to wear and tear. Another meaning given by Investopedia is, depreciation is an accounting method of allocating the cost of a tangible asset over its useful life. Google's definition is a little broader, and Investopedia's is a little more specific to real estate. Said another way, it is the decreasing value of an asset over time due to that asset experiencing use.
Rental Property Depreciation Rules
When depreciating residential real estate, there is one primary standard for depreciating residential rental property. One must use what is called the "Modified Accelerated Cost Recovery System" or (MACRS depreciation). Without going into much detail, MACRS is to get used for all residential rental property placed in service after 1986, so this article assumes that there's no one with a rental property placed in service before 1986.
Classes of Property
The way that MACRS works is there is different depreciation "systems" for different types of property. Here's an explanation: There are various property classes that describe the time frame or useful life of the property. Here are the different classes of property.
- 3-year property
- 5-year property
- 7-year property
- 10-year property
- 15-year property
- 20-year property
- Nonresidential real property and
- Residential rental property
Each one of these classes has a self-described "recovery period" when the property's value will be fully depreciated or "recovered." Most of them are self-evident, but for the last two, nonresidential real property and residential rental property have a recovery period of 27.5 years.
A more in-depth explanation is given later, but to begin forming the explanation, the amount depreciated each year will be able to be deducted as an expense against rental property income.
Depreciation Methods
Depending on the depreciation class, this will determine the depreciation method used.
Double Declining Balance
According to IRS rental property depreciation standards or MACRS, five, and seven-year property can use a 200% declining balance method(also known as double-declining balance method) of depreciation. The double-declining balance method depreciation formula is below:
Year 1 Depreciation Amount = Beginning Asset Book Value x (2 x (1 / Recovery Period))
Year 2 Depreciation Amount = (Beginning Asset Book Value - Year 1 Depreciation Amount) x (2 x (1 / Recovery Period))
Year 3 Depreciation Amount = (Beginning Asset Book Value - Year 1 Depreciation Amount - Year 2 Depreciation Amount) x (2 x (1 / Recovery Period))
Continuing each year in like fashion...
At a certain point in the future, a straight-line method over the remaining useful life of the property may give a more substantial depreciation amount. The IRS grants that it is allowable to switch to using the straight-line method of depreciation at that point.
150% Declining Balance
If the recovery period is 15 years, then the IRS allows a 150% declining balance method. The IRS also allows 150% declining balance for five and 7-year property if that is an investor's preference. The formula for a 150% declining balance will be very similar to the 200% declining balance depreciation formula. All that one needs to do is to replace the 2 (200%) with 1.5 (150%).
Straight-Line Depreciation
Use straight-line depreciation for a rental property that falls into the category of 27.5 year recovery periods. Straight-line depreciation gets explained more in-depth later, but this simply means that the cost basis of the property less the value of items that can't get depreciated, will be depreciated each year equally over 27.5 years. Here is the straight-line depreciation formula:
Year 1 Depreciation Amount = Beginning Asset Book Value x (1 / 27.5 Years)
Continue each year in like fashion...
MACRS IRS Depreciation Tables
For help making some of these depreciation calculations, consider visiting this IRS publication and viewing the MACRS IRS depreciation tables for reference.
Depreciation Conventions
Depreciation conventions are another subcategory for different types of real estate property. The purpose of conventions is to create a system to set the beginning and the end of an asset recovery period or useful life.
Why does the IRS create one more depreciation rule to follow? Conventions govern how real property that gets put into service in the middle of a year is treated from a depreciation perspective. For example, should the property be treated as put into service in the month that it gets put into service or the quarter that it gets put into service? At this point, depreciation can become reasonably technical, and it's advisable to keep a record of every detail and share that with your local tax advisor so they and direct as they see fit.
For more information on how depreciation works, be sure to visit the IRS Publication 527.
What Does This Mean Practically?
If a person can read through the above and understand it, they are ahead of the game. Now a person can begin to understand what that means for them practically in their real estate investing business.
How Does Depreciation Affect Taxes
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Income Taxes
Depreciation of rental property will, in effect, decrease a real estate investor's income tax from a rental property. This decrease occurs because if a rental property has any income before deducting depreciation, depreciation gets expensed against that to calculate a lower effective taxable income from the rental property. In many cases, depreciation in a given year is larger than income before depreciation, and so after depreciation gets expensed, no taxable income is left to report to the IRS.
What happens to the excess depreciation that doesn't get used? The IRS allows depreciation not used in a given year to be carried forward to a future year where it will be used or expensed against net income.
Taxes at the Sale of Property
What impact does rental property depreciation have on taxes when it comes time to sell the rental property? That is a critical question to ask as the effect is most often quite significant.
Typically, when an asset sells, an investor has to be concerned with capital gains taxes at the sale. That remains true with real estate as well, but an investor will also get taxed at the ordinary income tax rate for the recapture of depreciation. Yes, there will likely be capital gains tax as well as ordinary income tax.
Capital gains taxes get assessed on any property/asset appreciation that took place above and beyond the original purchase price of the asset.
Ordinary income taxes get assessed on any depreciation recaptured that was taken as a deduction against expenses in the previous year. It may seem confusing, so let's consider this rental property depreciation example.
Let's say that the original depreciable value of a rental property was $100,000, and the investor owned the property for 30 years, and all the depreciation ($100,000) has been used or taken. Now the real estate investor is ready to sell the property, and they believe the property will sell for $150,000. First, there will be a long term capital gain above and beyond what the property was initially purchased for, but there will also be an ordinary income tax based on the investor's marginal tax bracket assessed against the $100,000 of recaptured depreciation.
Let's say the investor is in the 25% tax bracket for simple math. That means the investor will pay $25,000 ($100,000 x 25%) in ordinary income tax from the sale of the property. And this doesn't include any capital gains tax that gets paid on the asset appreciation. Fortunately for real estate investors, the ordinary income tax rate for recaptured deprecation is capped at 25 percent for the time being.
For information from the IRS related to the depreciation recapture, consider reviewing this IRS publication.
1031 Exchange
That is where a 1031 exchange becomes very valuable in avoiding the depreciation recapture tax that the sale of a property creates. The 1031 exchange allows for a property to get sold and another "like-kind" property to get purchased without paying capital gains tax or ordinary income tax.
For more information on a 1031 Exchange, visit this IRS publication.
How Does Depreciation Affect Cash Flow
Based on the above heading, it may be surprising to hear that depreciation doesn't have a direct effect on a rental property's cash flow. However, depreciation does have a direct impact on a rental property's income taxes, and so depreciation does affect cash flow indirectly in that way. Depreciation indirectly has a positive impact on net cash flow by reducing the impact of taxes on net income. This point may seem counter-intuitive that an "expense" would have a positive impact on net cash flow.
Depreciation is what is called a "non-cash expense," which means that it can be used as an expense or deduction against income, but it doesn't cost the business anything out of pocket. Therefore, depreciation doesn't directly affect cash flow.
To calculate the final cash flow, depreciation expense must get added back in after it was deducted for purposes of calculating net income.
How Does Depreciation Affect Return on Investment
To answer this question, we must consider how the return on investment gets calculated. Return on Investment is the calculated IRR(Internal Rate of Return) of all future cash flows. Therefore, the above section just indicated that depreciation expense had a positive impact on net cash flow. Therefore, depreciation expense will have a net positive effect on our return on investment from rental property investment.
Remember that depreciation will affect the ordinary income taxes at the sale of the property, but because the sale of the property is potentially several if not many years in the future, its impact on the IRR calculation is less significant.
Using a Rental Property Calculator
IQ Calculators provides a free rental property calculator for its site visitors that automatically calculates depreciation. This rental property calculator allows the user to enter all income/revenue and expenses as well as information related to the purchase of the property. Based on this information, it calculates/estimates the property's depreciable value and estimates the property's annual depreciation over time. Based on your calculated net income estimates, the calculator will automatically carry forward any depreciation that doesn't get used in a specific year to a future year where it will be used. This helps ensure that all the depreciation contributes to calculating the investor's IRR and cash on cash return as accurately as possible.
To calculate depreciation separate from the rental property, IQ Calculators provides a depreciation calculator for its users.
Conclusion
Depreciation is one of the most significant tax advantages offered in the American tax system. Understanding how rental property depreciation works is a significant step to take toward building wealth in America. The tax advantages are great while owning the property and during the asset's useful life, but beware of all tax implications from the sale of the rental property. When selling, this may be an excellent opportunity to use a 1031 exchange to one's advantage. It would be wise to consult with a local tax advisor when considering the sale of a rental property. Good luck using all the advantages depreciation offers!
