Today we’re going to help you understand what rental property depreciation is and how it correctly works. One of the all-important reasons we invest in real estate in the first place is depreciation. It comes in handy and is mighty powerful, come tax time. In other words, it lets us keep more of our money in our pockets than sending it to the federal government.
So, if you’re trying to understand how depreciation works in rental property investment and what the details of depreciation are, definitely stick around!
What is Rental Property Depreciation and How Does It Work?
Real estate is one of the most tax-advantaged investment vehicles out there, and that is for a good reason.
Governments tend to structure tax codes to incentivize certain behaviors. Private owned rental property investment is one of those behaviors that they want to incentivize.
Appreciation, which is the rise in asset value, is a huge part of that. It allows investors to take advantage of some serious tax benefits in rental property investing.
Now let’s begin to understand what is depreciation.
What is Depreciation?
Imagine you own a car, and you intend to use it for a while. Now over the years, it is given that its condition will deteriorate. You’ll go out for drives, and exposure to anything will slowly start to erode its quality. In a few years, it will no longer look the same or function the same way.
What this means is that cars don’t appreciate, they depreciate over time.
Depreciation is a deteriorating condition over time.
To define the term clearly, the depletion of nonliquid assets in value over time because of deterioration is called Depreciation. You get to write off this piece of ownership over time.
The government recognizes that things fall apart. You probably have a great rental property, and you’ve rehabbed it. Over a certain period, set by the government, the rental property you own will practically fall to ruin.
But wait, practically speaking, it doesn’t actually happen. We don’t ever lose the value of a home. When you compare it to the stock market, stock can trickle down to zero. On the contrary, the rental property never crashes down to the same level.
In a down economy, it may face a dip in property value, but it is impossible to go down to zero over the long term.
Usually, 27.5 years is the amount of time that the federal government says your property will deteriorate. Now what’s great is that every year for 27.5 years, you get to claim on your taxes the depreciation of that property to offset your rental income.
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Calculating Rental Property Depreciation
Let’s discuss a specific scenario. Suppose the value of the home that you purchased was $50, 000, meaning the appraised value is about $50, 000.
Divide this value by the fixed amount of 27.5 years, which lands you at $1, 818. This is the exact amount you would get to claim on your taxes every year as the depreciation value of that purchased house, in general terms.
Now, what does that mean?
Rounding down to a solid $1, 800 from the scenario, this is the amount that comes off of your overall tax burden. If your rental income every year on that property is $5, 000, you get to offset that by $1, 818. So, deduct $1800 from the rental income, and now you have the amount to pay taxes on.
Can you spot the difference of the payment? You no longer have to pay taxes on $5, 000, which is an excellent way to alleviate your general tax burden.
Choose Rental Property Over Land
In America, rental real estate is the number one way to create a passive income, and there’s no better way. You might wonder what about owning raw land and leasing it out to people who want to put mobile homes or plant billboards on there. Although it is another excellent investment strategy, it is not as good as owning rental real estate.
Depreciation on Rental Property VS Land
One caveat is that the land where the house sits on is not depreciable. The market sets the value of land, and so it never loses its value. Even theoretically, it can’t fall apart in about 30 years. A house, a structure, a car – any asset can deteriorate.
Remember, what doesn’t deteriorate or has no chance of wrecking down, cannot be depreciated.
That is why, in the long run, owning rental real estate is far more profitable for anyone with the right mindset.
So that is depreciation at the necessary level of residential real estate.
What is Cost Segregation?
Now we’re moving on to the net level, and it is not for the faint of heart! Cost segregation came out in the new tax code of the U.S. about a few years back.
When they changed the tax code, the IRS set out a new statement. Now it allows the rental property owner or a real estate investor to depreciate certain portions of the house. Perhaps the roof needs a different rate of depreciation than the value of that of the cabinets.
In other words, the IRS now allows you to break down the depreciation costs over multiple terms, calling it to cost segregation.
Hire an Accountant
You can go pro by hiring a proper accountant who can do cost segregation. Have a seated discussion with them because you have to be eligible to do this.
If you own multiple properties, hiring a specialized accountant to do cost segregation can be worthwhile. A licensed accountant will dedicate all their time to going through every asset and break down the cost.
We hope you understood what rental property is and how powerful of a tool it is in helping you keep more money in your pocket.
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