Rental property depreciation is one of the biggest and most important deductions for real estate investors because it reduces taxable income but not cash flow.
For many landlords, the most important part here will be determining a property’s depreciable basis. The goal is to allocate as much of the property’s purchase price to the building value as possible to maximize your depreciation expense since land is never depreciated.
The portion allocated to the building will be depreciated over 27.5 years, per the IRS guidelines for residential income property.
While allocating 20% to land and 80% to the building is a common practice, under an audit you may have to substantiate why you chose these numbers. This is commonly done by finding the land versus building value on an appraisal or property tax card filed with the county.
You can also use comparable land sales to make this determination or commission a cost segregation study or appraisal by a third-party professional. Should you decide to deviate from the county tax assessor’s land-versus-building value ratio, you’ll need to be prepared to support your determination in an audit with independent documentation prepared by a third-party professional.
Cost Segregation Studies and 100% Bonus Depreciation
In a cost segregation study, certain costs previously classified as 27.5 year property are instead classified as personal property or land improvement with a shorter 5-, 7-, or 15-year rate of depreciation that uses accelerated methods to increase your near-term deductions.
Although it sounds complicated, most tax accountants and some software will do the math for you.
Generally between 20-30% of the property’s purchase price can be reclassified under these shorter class lives, which can significantly increase a property’s depreciation expense. Thanks to The Tax Cuts and Jobs Act, 5-, 7-, and 15-year property is now eligible for 100% bonus depreciation, meaning its entire cost can be written off in the first year its placed in service.
A building with a value of $100,000 will typically have $3,636 in annual depreciation ($100,000/27.5). However, if you commissioned a cost segregation study and find that 20% of the building’s value can be reclassified as personal property or land improvements, you could then deduct $20,000 in 100% bonus depreciation, and enjoy another $2,909 in regular annual depreciation for a total depreciation deduction of $22,909 in the first year.
Cost segregation studies make the most sense for landlords who are considered real estate professionals for tax purposes or expect to come in under the passive loss limits discussed below.
These studies may also be worth considering if you consistently have net income from passive activities or a capital gain from the sale of a rental, since losses generated by rental properties can generally offset other passive income or gain from the sale of rental property.
Check out more topics on rental property tax deductions:
- Rental Property Accounting Basics
- 9 Common Landlord Tax Deductions
- Business Travel Expenses for Rental Owners
- Pass-Through Deductions and Casualty Losses
- Capital Improvements vs. Repairs and Maintenance Expenses
- Passive Activity Limits and Passive Losses
- Capital Gains, Depreciation Recapture, and 1031 Exchange Rules
- Short-Term Rentals and Related Taxes
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