Today we’re going to talk about depreciation and how that affects your taxes. First I want to clear up, depreciation only applies to rental property you rent out to others and collect rental income. Not the home you live in. Also, today’s discussion applies only to those of you who are not real estate professionals, they fall under some different rules.
Rental property owners use depreciation to deduct the purchase price and improvement costs of the property from your tax returns over time, and depreciation is required by the IRS. There are a lot of rules involved and good record keeping is important. Depreciation is claimed as a deduction yearly, the information is carried over on your tax returns year after year, and will also impact your taxes when you eventually sell the property or the it out of service as a rental. See IRS publication 527 Residential Rental Property. https://www.irs.gov/publications/p527 Consider having an accountant do your taxes for your first year with the rental property to get your started out right, even if you do your own taxes again after that.
In short, depreciation can decrease the taxes you pay while you own the property and are earning rental income, but will increase the taxes you would otherwise pay when you sell it, something called recapture. Depreciation only applies to your rental property structure and improvements that typically wear out over time, not the land itse
Depreciation is calculated based on IRS rules and distributes the deduction across what the IRS considers the useful life of the property. You can find these depreciation tables in IRS Pub 527 and most tax preparation software have these tables built in.
So in the first year you put your rental property in service, you’ll have one depreciation schedule for what you paid for the house structure plus any immediate improvements, and expenses to get it ready to rent. That schedule will be updated each year with that year’s depreciation and a running total. Each additional improvement you make, will begin its own depreciation schedule.
At tax time, you deduct the depreciation allowed for that year from your rental income like you would other rental expenses on your tax form Schedule E. But you can’t deduct a rental property loss from your taxable income that year. It will be carried forward until your property reports a profit or is sold.
Depreciation starts as soon as you place the property in service as a rental property or when it's ready and available to use as a rental. So your first year’s taxes you may only be able to claim only a partial depreciation deduction.
When you sell your rental you will pay capital gains tax on the amount you receive from the sale minus its basis just like many other investments. But there is one tricky part. You will be subject to depreciation recapture. All the cumulative depreciation you claimed, will be taxed at your regular income tax rate in the year of the sale.
Calculations on the IRS Form for this are pretty convoluted, it’s an entire page. But the important thing to understand is the concept that the “profit” from the sale, that is the sale proceeds you receive minus what you originally paid and improvements you made, is taxed at a lower capital gains tax rate. The total depreciation that you reported over the years will be taxed all at once when you sell the property, or take it out of service, at your higher income tax rate. That’s the depreciation recapture that takes some first time rental property owners by surprise.
For information on how to figure and report any gain or loss from the sale, exchange, or other disposition of your rental property, see IRS Publication 544, Sales and Other Dispositions of Assets
