Depreciation has become synonymous with the reduction of an asset’s value. As a result, most homeowners have come to resent the idea of depreciation. Who doesn’t hate the idea of their assets losing value?
What many property owners do not realize is that depreciation can actually lead to significant tax benefits. When tax season rolls around, homeowners can use this information to secure deductions and reduce their overall tax burdens. The following home depreciation calculator can tell you how much money you can save on your deduction. Keep reading to learn more.
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What Is House Depreciation?
House depreciation is the cost deduction process used when buying or improving rental properties. Effectively, you can lower your tax liability by deducting expenses from your earned rental income. Home depreciation divides the deduction across the property’s lifespan rather than subtracting a larger, single deduction at the time of purchase or improvement. Again, as the IRS has specific house depreciation rules, it is essential to know how the home depreciation process works.
It is worth noting, however, that depreciation isn’t your enemy; it’s just misunderstood. Rental property depreciation is one of the most significant benefits awarded to qualifying passive income property owners. You see, the Internal Revenue Service (IRS) allows qualifying property owners to write off a portion of the asset’s initial cost each year in the form of “depreciation losses.” Therefore, qualified owners are allowed to recoup a portion of the initial cost of the home every year for as many as 27.5 years. Perhaps even more importantly, said deductions could reduce an investor’s tax obligations come tax time. The more they write off, the less they will have to pay in taxes.
How Does Property Depreciation Work?
To understand how depreciation works, you need to understand the rules set by the IRS. First, property depreciation can only be claimed if it is used for a business purpose, not for personal use. You or your business must be listed on the deed as the owner of the property. Items (excluding furniture) can depreciate, but they must have a determinable life span of over one year. The land that a property is on does not depreciate, but items such as new trees or plants near the property can depreciate. You can depreciate a rental property after it has been purchased and renovated and is available to be rented out. You can also take depreciation on a rental property if there is a period between tenants where repairs must be made to the property.
Kerry Sherin, Consumer Advocate at Ownerly, suggests that “depreciation is the reduction in value of a property over time. There are many factors that contribute to the value of your property. Many factors will need to be considered, including the current market, the condition of the home, and any changes to the neighborhood. Depreciation is influenced by the fair-market value of the home”.
How To Calculate Property Depreciation
To use a home depreciation calculator correctly, you must first identify three fundamental indicators: the property’s basis, the duration of recovery, and the method in which you will depreciate the asset. Here is how to use a property depreciation calculator step-by-step:
Identify the property’s basis
Separate the cost of land and buildings
Determine your asset depreciation method
Divide the basis by the duration of depreciation
Calculate adjusted basis
1. Identify The Property’s Basis
First things first, the property’s basis represents the total acquisition costs incurred from buying the home. The basis may include settlement fees, closing costs, and other expenditures that came out of your own pocket at the purchase time (think legal fees, back taxes, and insurance). That said, not all costs count towards the basis, so be sure to consult a tax professional for a better idea of what may be included. The land the home is sitting on, for example, may not be included in the basis.
2. Separate The Cost Of Land & Buildings
You must determine the cost of the structure and not the land. You can use the fair market value of each at the time you acquired the property to estimate the value. Alternatively, you can calculate the figure on the estimated real estate tax values.
3. Determine Your Asset Depreciation Method
Next, you’ll need to determine which method you intend to use to depreciate the asset. There are two distinct recovery systems: the General Depreciation System (GDS) or the Alternative Depreciation System (ADS). GDS is the most common, but again, be sure to consult a tax professional before moving forward with this step.
The General Depreciation System will allow owners to depreciate a portion of their initial cost every year over a period of 27.5 years. The Alternative Depreciation System will allow owners to depreciate a portion of their initial cost every year over a period of 40 years.
4. Divide The Basis By The Duration Of Depreciation
Once you have all the necessary variables, you will need to divide the basis by the duration of depreciation allotted by the IRS. Once again, rental property depreciation may be complicated, so do not attempt to depreciate a home on your own. Always consult a tax professional.
5. Calculate Adjusted Basis
Certain situations that can happen between the period you purchase the property and the time it is available to rent may require adjustments to your basis.
Increases in basis include the cost of any additions or improvements done before you place the property up for rent. These will include additions that have a useful life of at least one year, rehabilitations to damaged property, the cost of new utility services, and certain legal expenses.
Insurance payments received as a consequence of damage or theft, casualty loss not covered by insurance for which you claimed a deduction, and money received to grant an easement can all result in basis reductions.
How To Report Property Depreciation
Rental property depreciation can be reported on a Schedule E of Form 1040 when filing taxes annually. In certain cases, investors may need to use other forms or consult with a tax advisor. For example, if it is the first year the property was operated as a rental Form 4562 may be used to claim depreciation.
There are a few instances where depreciation cannot be reported, such as if the property was predominantly used as a primary residence and rented for 15 or fewer days. Consider depreciation deductions as you deduct other rental property expenses, like property taxes or insurance.
Housing Depreciation FAQs
Homes absolutely depreciate. As a physical asset, time takes its toll on any and every home on the market. Perhaps even more importantly, that’s how the IRS sees it, too. The powers that be (the IRS) have been kind enough to offset said depreciation with an allowance of sorts.
Otherwise known as depreciation losses, the IRS is willing to give rental property owners “allowances for exhaustion, wear and tear (including obsolescence) of property.” According to their website, “You begin to depreciate your rental property when you place it in service. You can recover some or all of your original acquisition cost and the cost of improvements… beginning in the year your rental property is first placed in service, and beginning in any year you make improvements or add furnishings.”
1. Do Homes & Rental Properties Depreciate?
In the eyes of the IRS, they most certainly do. However, as I am sure you are already aware, homes don’t always depreciate in the actual housing market. More often than not, homes tend to appreciate — at least that’s what history suggests. Therein lies the greatest depreciation benefit of them all: phantom losses. Imani Francies, investing expert from Clearsurance, describes phantom income like this: “Phantom income refers to an investment gain that has yet to be realized through a cash sale or dividend. For a partnership or an individual, however, it still causes a tax burden. When an individual is taxed on the value of their interest in a partnership or any similar arrangement, even though they do not get any monetary benefits or payments, this is known as phantom income”.
Again, the IRS has already said it accepts that homes will depreciate over a 27.5 year period. As a result, qualifying rental property owners can write off a portion of the original cost each year, effectively reducing their tax obligations. However, home values typically rise over time. So while many rental property owners are allowed to claim depreciation, the actual value of their home may, in fact, increase over time.
2. How Much Does A Home Depreciate Per Year?
Homes depreciate 3.636% per year, on average, according to Investopedia. That number is reserved for homes placed in service for an entire year, however. Homes that were only placed in service for a portion of the year will only be allowed to depreciate a portion of the average compared to when it was in service.
3. What Factors Affect Property Value?
Seven factors affect property value more than anything else. And while the following factors are in no way representative of everything that influences a home’s value, they are perhaps the most important — the tent poles, if you will:
Age And Condition
First and foremost, those looking to value a home properly will resort to their own sales history and the sales history of nearby comparables. That way, the valuation will be based on historic data and not something that is—at best—questionable. Next, a proper evaluation will consider the home’s location. Everything from the zip code, city street, and neighborhood all go into a proper evaluation. It is true what they say: real estate is all about location, location, location. Another prominent factor in valuing a property is the current state of the market. If for nothing else, supply and demand play a huge role in determining value. Low inventory levels, coupled with high demand, will certainly drive up prices. What’s more, prices can just as easily drop in the face of inventory surpluses without a demand. And finally, there’s the house itself. The size, style, age, and condition are all factored into a proper evaluation.
Countless factors go into properly determining a home’s value— too many to count even. The seven I hit on above are the most important and perhaps even the reason most homes tend to appreciate more often than not. At the very least, it’s these factors that combine to make deprecation losses even more rewarding for homeowners.
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4. What Is The House Depreciation Rate?
The house depreciation rate will depend mainly on the system you intend to use, as there are two primary ways to calculate your own deprecation. If you depreciate your asset using the General Depreciation System, which lasts 27.5 years, “you would depreciate an equal amount: 3.636% each year as long as you continue to depreciate the property,” according to Investopedia. However, using the Alternative Depreciation System (ADS) will span upwards of 40 years and result in a subsequent house depreciation rate.
That said, using a home depreciation calculator to calculate your own home’s depreciation rate is no simple task. It is a complicated process at best and should be left to a trained tax professional.
5. What Is Accelerated Depreciation?
As its name suggests, accelerated depreciation suggests an asset is losing value at a faster rate. Or, as InvestingAnswers so eloquently puts it, “Accelerated depreciation is a depreciation method whereby an asset loses book value at a faster rate than the traditional straight-line method. Generally, this method allows greater deductions in the earlier years of an asset and is used to minimize taxable income.”
It’s important to note that accelerated depreciation takes place in the earlier years of an asset. As for rental properties, the earlier years are the first 27.5, at least according to the Modified Accelerated Cost Recovery System (MACRS). Created in place of the Tax Reform Act of 1986, the MACRS grants rental property owners the ability to depreciate their assets over a period of 27.5 years — the “early” stages of a property. That said, the entire process of depreciation is a product of accelerated depreciation.
6. How Do You Increase The Market Value Of A Property?
Learning how to increase the market value of a property, in addition to rental property depreciation, can really help a homeowner’s bottom line. That said, if you want to increase the perceived value of your own home, try implementing some of these projects that have some of today’s best return on investment (ROI):
Mid-range Bathroom Remodel: The average mid-range bathroom remodel will cost homeowners approximately $19,143, but will recoup about 70.1% of the cost if the home is sold.
Steel Entry Door Replacement: The average steel entry door replacement will set owners back about $1,471, but recoup about 91.3% at the time of a later sale.
Mid-range Kitchen Remodel: A mid-range kitchen remodel costs about $63,829, but could recoup as much as 59.0%.
Siding Replacement: On average, it costs about $15,072 to replace siding on a home, but the project could recoup 76.7% at the time of a sale.
7. What Are The Types Of Home Depreciation Calculators?
All physical assets, real estate included, depreciate over time, particularly in the IRS’s eyes. However, the depreciation deductions available will actually vary based on what the home is used for. For property owners, this means your potential tax savings will depend on the investment type. This information is important to consider as you evaluate the potential returns of different real estate deals. Here is an overview of the depreciation of houses by property type:
Rental Property: One of the greatest benefits to owning a rental property is the depreciation deduction. Investors can follow the steps above when calculating the depreciation of any passive income properties.
Main Residence: Personal properties are not eligible for the depreciation deduction. This is because depreciation specifically applies to income-generating assets or investments. To keep things simple: homeowners do not earn income from their property and therefore cannot use the depreciation deduction.
Owner-Occupied Duplex: Duplexes navigate a fine line when it comes to depreciation. Essentially, property owners will treat the units as two separate properties. For tax purposes, the tenant-occupied portion would be depreciated while the owner-occupied portion would not.
Home Office: According to the IRS, home offices are treated similarly to commercial properties. The property will need to determine the percentage of the home that the office occupies to determine the deductions available. Additionally, commercial real estate can be deducted over a 39 year period.
8. When Does Property Depreciation Start?
As soon as a property is ready to be utilized as a rental, depreciation deductions can begin. For example, if you purchase the property on January 1st, renovate it, have it ready to rent on April 1st, and finally find a tenant on May 1st, house depreciation would start on April 1st. While you do not collect rent from your tenant until May, house depreciation starts on the first day it is available for rent.
9. What Is “Useful Life” Of A Property
As mentioned above, the two systems for determining the useful life of a property are the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). In general, you can choose which system you would like to use, but some businesses are required to use one or the other. However, once you choose, you need to stick with that system for as long as you claim depreciation on that property.
We already discussed useful life for residential properties, but it applies to nonresidential as well. Under GDS, the lifespan for a nonresidential property is 39 years, and 40 under ADS. Useful life does not apply to land because it cannot depreciate.
[ Do you want to know the deprecation rates for commercial real estate? Read this article to learn more ]
Depreciation Recapture For Rental Properties
While there is not a “catch” to worry about when it comes to to depreciation deduction, property owners should be aware of recapture. Essentially, anytime the IRS doles out a benefit, such as a deduction, they will expect a return in the future, typically called a recapture. In the case of the depreciation deduction, this cost is incurred after the rental property is sold. Property owners will need to pay taxes on the amount of money they depreciated, or were allowed to depreciate regardless of whether or not they used the benefit.
Recapture should not deter you from accessing the depreciation deduction. First of all, you will be charged either way when selling a rental property. Second, the deduction can serve to reduce your income taxes while you own the property. It can also help you to avoid capital gains. These potential benefits should outweigh the cons when it comes to managing your real estate portfolio.
Systems such as a home depreciation calculator are currently put in place to make sure you are depreciating your own asset accordingly. To be certain, I recommend hiring a trained tax professional. You just might find it to be the one advantage you have been looking for.
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