Depreciation is one of the most important features for real estate businesses apart from their regular expenses. It allows you to reduce your taxable income, paying less in taxes and sometimes paying no tax at all. Legally.
However, keeping track of residential rental property depreciation can be overwhelming, especially for property owners without a background in accounting. Some real estate investors end up paying more taxes than they should for failing to understand how depreciation works. While a tax accountant is a must-have to ensure you are not on the wrong side of the Internal Revenue Service (IRS) come April, keeping excellent records of your own for easier property depreciation management is also important.
This article will show you how depreciation reduces your tax liabilities and how a rental property depreciation spreadsheet can help you with this. Plus, we’ve included a free downloadable spreadsheet to get you started.
How rental property depreciation works
Depreciation is the reduction of an asset’s wear-and-tear costs, which reduces its value over its useful life. In accounting, this depreciation cost is allocated to the asset’s remaining value through its life until the asset’s initial cost is depleted. How does this work?
The IRS allows businesses to expense this depreciation cost as a noncash expense until the asset is fully depreciated. Since you will not expense the cost of attaining or improving the property at once, the depreciation cost ensures you expense this cost over your property’s life. This distribution of the depreciation expense over the property’s lifetime allows you to lower your tax liability every year until the cost is fully utilized.
There are different depreciation methods, which is what makes rental property depreciation touchy. The wrong method or figures will affect your overall rental business bottom line and tax liability. The IRS is quite specific on depreciation methods for property owners, which entails the use of the Modified Accelerated Cost Recovery System (MACRS) for properties placed in rental services after 1986.
The MACRS has several systems that affect the recovery period of an asset, depending on the property class. However, the straight-line depreciation method is generally used for residential rental properties. That means every residential property will be depreciated over 27.5 years.
Straight-line depreciation method is quite simple since it only requires you to divide the cost of acquiring the property, also referred to as the basis, over the useful life of 27.5 years. That means that the depreciation cost remains the same throughout the life of the property using this method.
For example, assume the cost or basis of the property is $80,000, excluding the land value and without factoring in other costs of acquiring the property that must be capitalized. The depreciation expense will be $2,909.09 ($80,000/27.5) every year.
However, if you acquire, renovate, or sell the property midyear, you will have to prorate the depreciation cost and account only for the months you have owned the property in that first or last year.
Following our above example, let’s assume you acquired the property in July but put it in service in September. Your depreciation cost for the first year will only start from the period you put it in service, not the whole year or when you acquired it.
The math sounds complicated, right? Well, it doesn’t have to be much of a headache. The IRS has provided a table of shortcut rates one can use to multiply with the basis of the property. Using our above example, your depreciation for the first year will be $848.80 (1.061% x $80,000). You can depreciate the property from the second year at 3.636% (100%/27.5 years):
The above example only considers the value of the property only as the basis of our depreciation calculation. As a rental property owner, you already know the process of acquiring any property comes with additional costs. Luckily, the IRS allows you to add qualified expenses to the property’s value to arrive at the correct basis for depreciation costs. These qualified costs include:
- Abstract fees
- Property fees
- Transfer taxes
- Legal fees
- Utility services installation costs
- Title insurance
- Recording fees
- Survey fees
- Real estate commissions
- Interest fees
A free rental property depreciation spreadsheet (and what it should include)
Now that you know how rental property depreciation works, what should you include in your depreciation sheet to make calculations easier over the years?
Besides the property’s purchase value, your depreciation spreadsheet also needs to have:
- Property details – in case you have multiple properties, you can keep track of each property separately
- The land value – to be subtracted from the property value
- The closing costs – are to be added to the purchase value
- Depreciation period – ideal for knowing when to prorate based on year and month of purchase and sale
Simply select the link and download it to your computer (or make a copy to edit it online). After you open the spreadsheet, save it by another name so that you always have the original document to go back to.
Automate your rental property depreciation with Stessa
When you use Stessa to manage your rental property depreciation, you’ll never have to worry about manually updating a spreadsheet again. That’s because Stessa automatically updates the real estate balance sheet for you, so you can always stay on top of your finances.
Stessa, a Roofstock company, offers free cloud-based software that helps real estate investors maximize profits through smart money management, automated income and expense tracking, personalized reporting, rent collection, and more. More than 100,000 investors already use Stessa to track over 250,000 properties with more than $60 billion in asset value.
Stessa also offers other great benefits for landlords and real estate investors, like:
- The ability to track rental property expenses and income across multiple properties in one place
- Detailed reports and analytics to help you make informed decisions about your investments
- A streamlined tax-filing process come tax time
To get started, sign up for a free account with Stessa today and see how easy keeping track of rental property depreciation can be.
How depreciation saves you money on taxes
As stated earlier, depreciation is an essential tool for rental property owners as it helps reduce one’s tax liability. But how does it do this?
Your depreciation cost is treated as a business expense, although you do not incur it as cash like other costs of running your rental business. When filling your rental property taxes using Schedule E, there is a line item for depreciation where you have to fill in the depreciation cost for the year.
Your tax bracket will also affect your overall tax liability. Using our earlier example, let’s also assume you are in the 22% tax bracket and your depreciation cost for the year is $2,909.09. When you expense this cost, it will reduce your rental income profit, thus lowering the tax payable. In simple terms, this cost will save you $640 in taxes ($2,909.09 X 22%).
Accounting jargon might sound just like that, jargon. However, when it comes to rental property depreciation, you need to be on your toes with the happenings of your rental business. It will help you lower your tax liabilities over the life of the property.
With our customizable rental property depreciation spreadsheet, you can now estimate how much depreciation you need to capitalize. However, tax laws are pretty complicated, moreso for rental properties. So, despite having your own figures, it is important to work with a professional, like a tax accountant, to ensure the amount you claim is correct.