Tax Depreciation for Investment Property
Real estate investors use depreciation to deduct the purchase price of a rental property and any improvements that extend the life of the property or increase its value. Unlike other deductions that are taken in one year, depreciation allows you to spread the costs of buying or improving a rental property over time so that you can deduct them gradually and evenly.
Depending on the method of depreciation you choose, depreciation can lower your taxes, particularly when it comes to capital gains. Moreover, when you sell your property, depreciation expenses can determine how much of the gain you recognize. If you’re a high-income taxpayer, you might also be subject to the 3.8% net investment income tax (NIIT).
How Does Tax Depreciation Work?
Generally, you depreciate property for the life of its useful life or until you retire it from service. You can choose to depreciate your property using a straight line, accelerated depreciation or a combination of both. You may also claim the section 179 deduction, if eligible.
The cost basis of a property is the amount you paid for it plus the land on which it stands, if it is not held in trust. The basis of a property can include any other costs that you add to the property over the life of its useful life, such as any capital improvements you make to it.
Most property owners will begin to depreciate their investment properties when they place them in service as a rental activity. This can happen even if they don’t actually rent the property out, but only when it is ready and available for its specific purpose in that activity.
You can depreciate residential rental property, nonresidential business or commercial properties using the Modified Accelerated Cost Recovery System (MACRS). For all property placed in service after 1986, MACRS uses a number of methods to determine when you can start and stop claiming depreciation.
For residential property, you can use the straight line or declining balance methods to calculate your depreciation percentage over 27.5 years. For nonresidential property, you can depreciate using the straight line or accelerated method over a shorter period, such as 5 or 7 years.
Conventions
For nonresidential property, you can use the mid-month convention to determine when you can begin claiming depreciation. You can also use the straight line or accelerated method to start claiming depreciation for residential property that you place in service after 1986.
You can use the straight line or accelerated method to calculate your depreciation percentage over a shorter period, such as 5 and 7 years. For property in the 5- and 7-year class, you can use the 200% declining balance method.
The MACRS conventions apply to all property placed in service in a calendar year and to all property you dispose of that same year. The only exception is if you purchased the property before January 1, 1981, and you are claiming it under the first-year recovery period of the MACRS.
