How Depreciation is Calculated On Rental Property
Real estate depreciation can be viewed as a complicated real estate concept, but once it is understood, its not really that complicated. This article is going to form an explanation of what real estate depreciation is, why you should care, and how depreciation works.
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 right...in light of all the other tax advantages in the tax code? But it may be true. To prove my 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 important because any time taxes can be avoided, then it means that 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 depreciation is broken down into how it works, lets start with the basics. What does depreciation mean? According to Google, depreciation is a reduction in the value of an asset with the passage of time, particularly 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 more broad and Investopedia's is a little more specific to real estate. That's what depreciation is though, it is the decreasing in value of an asset over time due to that asset experiencing use.
Rental Property Depreciation Rules
This section seeks to answer "How to depreciate rental property." 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 be used for all residential rental property placed in service after 1986 so this article will just assume that there's no one with rental property that was placed in service before 1986.
Classes of Property
The way that MACRS works, is there are different depreciation "systems" for different types of property. Here's an explanation: First, there are different property classes. This describes or informs the time frame or useful life of the property. Here's 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.
This will be explained more in depth 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.
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 larger 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 5 and 7 year property if that is an investor's preference. The formula for 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%).
Staight Line Depreciation
Straight line depreciation should be used with rental property that falls into the category of 27.5 year recovery periods. This will be explained more in depth later, but this simply means that the cost basis of the property less the value of items that can't be depreciated, will be depreciated equally each year over a time period of 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 are another sub category for different types of real estate property. The purpose of conventions is to create a system by which to set the beginning and the end of an assets recovery period or useful life.
Why does the IRS create one more depreciation rule to follow? Conventions govern how real property that is put into service in the middle of a year is to be treated from a depreciation perspective. For example, should the property be treated as put into service in the month that it was put into service or the quarter that it was put into service. This is where depreciation begins to become fairly technical and its advisable to keep 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 beging to understand what that means for them practically in their real estate investing business.
How Does Depreciation Affect Taxes
Depreciation of rental property will in affect decrease a real estate investor's income tax from rental property. This is because if a rental property has any income before deducting depreciation, depreciation will be expensed against that in order 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 is expensed, no taxable income is left to report to the IRS.
What happens to the excess depreciation that wasn't 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 very important question to ask as the impact is most often quite significant.
Normally, when an asset is sold, an investor has to be concerned with capital gains taxes at the sale or the property. That remains true with real estate as well but an investor will also be 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 tax will be assessed on any property/asset appreciation that took place above and beyond the original purchase price of the asset.
Ordinary income tax will be assessed on any depreciation recaptured that was taken as a deduction against expenses in a 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 depreciaton ($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 originally 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 will be paid on the asset appreciation.
For information from the IRS related to the depreciation recapture, consider reviewing this IRS publication.
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 be sold and another "like-kind" property to be 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 affect 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. To put it succinctly, depreciation indirectly has a positive impact on net cash flow by reducing the impact of taxes on net income. This 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 actually cost the business anything out of pocket. Therefore, depreciation doesn't directly affect cash flow.
In order to calculate final cash flow, depreciation expense must be 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 return on investment is 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 impact on our return on investment from a rental property investment.
Its important to remember that depreciation will affect our 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 internal rate of return calculation and thus our return on investment is less important.
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 isn't used in a certain 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.
Depreciation is one of the greatest tax advantages offered in the American tax system. Understanding how rental property depreciation works is a great 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 a great 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!