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All About Depreciation of Rental Property You Need to Know

Depreciation of Rental Property
Depreciation is an effective tax shelter for people who rent out their properties. This article will help in understanding the term rental depreciation and how it can help you.
WealthHow Staff
Last Updated: May 31, 2018
Assets provide a financial security to the owner against future expenses, inflation, and contingencies. However, every such entity undergoes wear and tear. Real estate properties are no different.

Definition: Depreciation of rental property can be defined as the steady rate of decrease in the value of a passive rental property owned by a person.

Rent collected on property is also a source of income. This income is taxable, but then the depreciation costs, repairs, and operating costs are considerable amount of tax deductions that can be made on the rental income. For investors, this is good news, as the taxable portion of the income from property is recovered through the rental depreciation. As per the Internal Revenue Service (IRS), the factors that determine the amount of depreciation are: the recovery period for the property owned, the owner's claim on the property, and the kind of depreciation methods used. Importantly, this applies only to the structure or building and not the cost of land.

To avail these benefits, many investors allocate much of their property purchase price to improvements and little to land. For example: A tax assessor has shown on paper that he has 95% of his property that is attributable to improvements and 5% to land. This is accepted by IRS, although the distribution by the tax assessor may not be actual. When a property is shown as attributable to improvements, the depreciation costs are deductible expenses, which provide an effective tax shelter for rental properties. Let's take an instance. Assume there is a property which has cash flow worth USD 5,000. Say, the income is exceeding the cash expenditure annually by USD 5,000. Now the investor has a surplus of USD 5,000 in hand. If this were depreciated as USD 10,000 in that financial year, the property would have suffered a loss of USD 5,000. But if it is shown as USD 5,000, the spendable income would remain untaxed and the remaining USD 5,000 (depreciation cost) would be used to offset other incomes. This is how it helps in tax sheltering.

Calculation

Let's take a look at the method to calculate rental property depreciation, on an annual basis:

Annual depreciation = (Purchase price - Cost of the land) / Lifespan

where:
Annual depreciation: is the amount of expenses that can be claimed on a yearly basis.
Purchase price: is total price that has been paid for the property.
Cost of the land: value of the land on which the property stands.
Life span: is the number of useful years for the property.

Let's take an example: John has bought a property worth USD 250,000. The land value is USD 50,000. The residential property is depreciated over 20 years.

Going by the above formula,
Annual Depreciation = (250,000 - 50,000) / 20 = 200,000 / 20 = USD 10,000

Nowadays, there are many property management software available, which can be of immense help when calculating rental depreciation.