The basics of depreciation on investment property

Depreciation can be complicated, but it's important to understand if you own property as an investment.

Depreciation can be complicated, but it's important to understand if you own property as an investment.

 

Many Americans take advantage of a spare bedroom, or even a second home, for use as a rental property. These arrangements have the potential for helping pay off mortgages must faster and potentially earning a sizeable second source of income. However, there are many financial quandaries that investment property owners could find themselves in without proper planning. One of the harder things to nail down is depreciation, and how it will affect a home's resale value and the owner's tax obligations.

Depreciation basics

Just about anything that's bought or sold tends to lose value over time, whether from the effects of age or simply due to market forces. Depreciation is a regular phenomenon that plays an outsize role in real estate, when the loss of a small percentage of value could equate to thousands of dollars. It's also important to understand depreciation due to its influence on taxation. The IRS has standards in place that allow property owners to calculate and report the depreciation of assets like real estate or land. Owners of depreciable assets are then eligible for certain tax allowances.

To qualify for a tax deduction for depreciation, the IRS requires taxpayers to meet all of the following criteria:

  • The taxpayer must own the property, and be able to prove this ownership as well as provide record of renovations (if they wish to account for the value of these additions).
  • The property must be used in a business capacity. If a home is used as the taxpayer's residence as well as an investment, he or she is only allowed a deduction on business expenses.
  • The property's "useful life" must be at least one year.

If all of these conditions are met, the property owner is probably eligible for certain tax deductions. Realtor.com explained that these tax breaks can cover depreciation caused by routine wear and tear, along with subsequent repairs. Property taxes and mortgage insurance also qualify. What some homeowners don't always realize, though, is that some renovations can have their value deducted over several years. For example, the IRS considers the useful life of a typical residential property to be around 27.5 years, but something like a new water heater could have a useful life up to five years. 

TaxesBe prepared for tax season by understanding depreciation and how it impacts your investments.

This might become more useful for large expenses, like room additions. For example, Realtor.com explained that a major renovation that cost $40,000 would, of course, make for a large deduction in a single year, but would make the next year's tax return much lower. To smooth out the shock in this situation, the owner could instead stretch that deduction over several years.

Straight line deduction

The most basic way to calculate depreciation for tax purposes is the "straight line" method. This is equal to the asset or renovation's salvage value subtracted from its total cost to the owner, and then divided by the estimated useful life. Doing this for every repair or addition should provide a rough estimate of how much you'll be able to claim as a deduction on that year's taxes.

When it comes to estimating the depreciation of an entire home, however, the math becomes more complicated. It's advisable that anyone with a second home being used for rental purposes consult a CPA for help with this reporting. This will virtually ensure the numbers are accurate and that you're paying the right amount in taxes, and not spending more than you need.