Depreciation is a tax deduction that allows you to recover a property’s cost over time. You can typically write off the wear and tear on your residential long-term rental property in equal installments over 27.5 years or 39 years for many short-term rentals.
Sometimes, landlords question whether to claim depreciation on rental property. The decision can significantly impact your taxable income and overall cash flow.
In this article, we explore the pros and cons of depreciation, illustrating the vital financial impact of rental property depreciation with specific examples. Then, we explain how you can keep track of cost basis, capital expenses, and other inputs that are essential to calculating rental property depreciation and thereby maximizing your return on investment.
Reasons why some owners skip depreciation on their rental properties
Claiming rental property depreciation requires extra effort, detailed calculations, and an understanding of tax laws. These are just a few reasons why some landlords skip reporting depreciation. However, some common misconceptions may also play a role in their decision.
They think it takes too much time
Owning rental properties requires real estate investors to gather and organize records, calculate depreciation accurately, and complete the necessary tax forms. This process can be especially burdensome for anyone who manages multiple properties or has other demanding responsibilities.
For example, a landlord with a full-time job may feel that they don’t have the time or energy to dedicate to calculating and claiming depreciation. In this case, skipping depreciation could simply be the result of efforts to save time and simplify the tax filing process.
They think claiming depreciation is complicated
Some owners may skip deducting depreciation because they don’t know how to calculate and claim it accurately. The ins and outs of tracking property wear and tear, compliance with IRS guidelines, and applying the proper depreciation schedules and tables can seem overwhelming.
While that’s an understandable concern, software designed specifically for rental property owners can facilitate the process. With built-in automatic tracking for income and expenses, owners can more easily claim the deductions they’re entitled to without added stress or confusion.
They think it could negatively impact cash flow
Other landlords worry that claiming depreciation could result in lower income from their property, reducing their cash flow. However, depreciation isn’t an actual cash expense; it’s simply a tax deduction.
In other words, depreciation may lower your taxable income, but it doesn’t affect your cash flow. In fact, by lowering your taxable income, you could pay less in taxes, potentially giving you more cash on hand.
They think it can reduce the property’s market value
Another misconception is that claiming depreciation may ultimately decrease the value of a rental property. Potential buyers might view a fully depreciated property as less valuable, making it more challenging to sell in the future.
But that isn’t true. Depreciation is a tax deduction with no impact on the actual market value of your property. It’s simply an accounting method to help spread out the cost of your property over time for tax purposes.
They fear it increases the risk of being audited
Some landlords believe that a simplified tax return is less likely to attract attention from the IRS. They may avoid claiming depreciation to minimize the audit risk, thinking that the less complicated their return, the lower the chance of facing an audit.
On the contrary, according to data from the IRS, the odds of an individual return being audited are about 2%. If your reported annual taxable income is between $200,000 and $500,000, your audit risk decreases to 1%.
They want to avoid depreciation recapture
Another misconception some real estate investors have is that not claiming depreciation during ownership helps them avoid paying the depreciation recapture tax when a property gets sold later.
However, the IRS requires owners to pay the depreciation recapture tax regardless of whether they claimed the depreciation expense over their holding period. So, instead of eliminating the tax liability, skipping depreciation may actually increase your overall tax liability. By not reporting depreciation, you’re missing out on a significant tax deduction each year and may eventually end up paying recapture tax on a deduction you never claimed.
Key reasons why you’d want to depreciate a rental property
So, what are the key reasons for depreciating your rental property? Depreciation offers several significant benefits and can be a valuable tool for landlords and investors.
Reduce taxable net income
Depreciation allows you to lower your taxable net income by writing off the cost of your rental property over several years. By reducing the amount of your income subject to taxation, you can effectively lower your tax liability.
The savings can be substantial, freeing up funds to strategically reinvest in your property or other ventures and helping you better manage your finances. This tax benefit is one of the primary reasons savvy property owners choose to depreciate their rental properties.
Increase cash flow
Depreciation can boost your cash flow by lowering the amount you owe in income tax. You can reinvest the tax savings from depreciation into your property or use it to cover other expenses.
With more available cash, you can fund other monetary obligations like operating expenses or capital improvements. This key benefit can significantly improve the financial health of your rental business.
Offset operating expenses
Operating a rental property includes numerous expenses, from maintenance and repairs to property management fees. Depreciation can help offset these operating costs through a tax deduction that reduces your taxable income, leaving you with more cash.
By offsetting your operating expenses, you can maintain a more balanced budget, which helps ensure your rental property remains profitable. This benefit may also help you increase the value of your property over the long term by providing you with additional cash to invest in capital improvements or other upgrades.
Recover the cost of improvements
When you make improvements to your rental property, such as adding a new roof or renovating a kitchen, you can often recover a portion of the cost through depreciation. You can deduct the value of these improvements over time, reducing your taxable income and providing additional tax savings.
Recovering the cost of improvements also offers a financial incentive for landlords who want to improve and maintain their properties regularly. You may be able to invest in necessary upgrades more easily while still keeping your overall cash position healthy.
Long-term tax strategy
Depreciation can be an essential long-term tax strategy for property owners. By claiming depreciation consistently, you can systematically reduce your taxable income over the years, leading to significant tax savings.
A well-executed depreciation strategy aligns with other tax planning measures such as 1031 exchanges and capital gains tax management, allowing you to maximize your overall tax savings. It’s a critical tool for any property owner looking to build and sustain wealth.
Other benefits
Finally, depreciation can enhance your investment portfolio, demonstrating a disciplined method of property management and tax planning. It shows potential investors and lenders that you’re making the most of available tax benefits, which can be useful when refinancing or participating in a partnership.
Additionally, depreciation can help you build equity in your property by allowing you to reinvest tax savings into property improvements. That can increase your investment property’s value over time, further boosting your returns.
Running the numbers to decide if you should or shouldn’t depreciate
Example 1: Not depreciating a rental property
Consider a rental property with a total purchase price of $250,000, including closing costs. The land value is $50,000, leaving the building value at $200,000. The holding period for this property is 5 years. Following is the financial impact of not depreciating this property over that period.
Annual rental income and expenses: Assume the property generates an annual rental income of $24,000. Yearly operating expenses, including maintenance, property management, insurance, and taxes, total $12,000. That leaves you with a net rental income of $12,000 annually.
Impact on taxable net income: Without depreciation, the net rental income of $12,000 is fully taxable each year. Over 5 years, that total taxable net income amounts to $60,000.
Tax liability: Assuming a 22% tax rate, your tax liability on $12,000 of annual net rental income is $2,640. Over 5 years, your total tax liability amounts to $13,200.
Cash flow before taxes: Without depreciation, your annual cash flow (before taxes) is $12,000. However, after accounting for the tax liability, the after-tax cash flow gets reduced to $9,360 per year ($12,000 minus $2,640). Over 5 years, you’d have a total after-tax cash flow of $46,800.
Example 2: Depreciating a rental property
Now, let’s consider the same rental property with the depreciation expense.
Annual depreciation deduction: The IRS allows you to depreciate your long-term residential rental property over 27.5 years. For a building value of $200,000, the annual depreciation deduction is approximately $7,273 ($200,000 divided by 27.5 years).
Annual rental income and expenses: Assume the property generates an annual rental income of $24,000 and operating expenses totaling $12,000, leaving you with a net rental income of $12,000 annually.
Impact on taxable net income: With the depreciation deduction, your taxable net income is reduced by $7,273 annually. That means your taxable income is $4,727 annually ($12,000 minus $7,273).
Tax liability: Assuming a 22% tax rate, your tax liability on $4,727 of annual taxable net income is approximately $1,040. Over 5 years, your total tax liability amounts to $5,200.
Cash flow before taxes: With depreciation, your annual cash flow before taxes remains $12,000. However, after accounting for the tax liability, your after-tax cash flow is $10,960 annually. Over 5 years, that results in an after-tax cash flow of $54,800.
How depreciation impacts tax liability and cash flow
Impact on tax liability
When you compare the tax liability of not depreciating your rental property versus depreciating it, the difference can be quite significant.
Without depreciation:
- Annual net rental income: $12,000
- Total taxable net income over 5 years: $60,000
- Tax rate: 22%
- Total tax liability over 5 years: $13,200
With depreciation:
- Annual depreciation deduction: $7,273
- Annual taxable net income: $4,727 ($12,000 – $7,273)
- Total taxable net income over 5 years: $23,635
- Tax rate: 22%
- Total tax liability over 5 years: $5,200
By depreciating your rental property, you reduce the total taxable net income over 5 years from $60,000 to $23,635, resulting in a tax liability decrease of $13,200 to $5,200 and a savings of $8,000.
Impact on cash flow
Next, let’s analyze the impact on cash flow after taxes when factoring in depreciation.
Without depreciation:
- Annual net rental income: $12,000
- Tax liability: $2,640 annually
- After-tax cash flow: $9,360 annually
- Total after-tax cash flow over 5 years: $46,800
With depreciation:
- Annual net rental income: $12,000
- Depreciation deduction: $7,273 annually
- New tax liability: $1,040 annually
- After-tax cash flow: $10,960 annually
- Total after-tax cash flow over 5 years: $54,800
When you claim depreciation, your annual after-tax cash flow increases from $9,360 to $10,960. Over 5 years, this increases your after-tax cash flow from $46,800 to $54,800, giving you an additional $8,000 due to the depreciation deduction.
How to report rental property depreciation
Use Schedule E (Form 1040) to report your rental property depreciation, alongside other income and expenses related to your rental real estate.
On Schedule E, you detail the depreciation expense for each rental property you own. Enter the depreciation amount on Line 18, “Depreciation expense or depletion,” which reduces your overall rental income and lowers your taxable income.
Other line items on Schedule E include Line 3, “Rents received,” where you report your total rental income, and Lines 5 through 20, which cover various expenses like advertising, repairs, insurance, and management fees.
In addition to Schedule E, you may need to fill out Form 4562, “Depreciation and Amortization,” to calculate the depreciation deduction for your property. Form 4562 helps you determine the correct amount to deduct each year based on your property’s cost, useful life, and the depreciation method chosen.
Streamline your tax prep with Stessa
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