What is Depreciation?

You recover the cost of income producing property through tax deductions. You do this by depreciating the property. The definition of depreciation is the “annual income tax deduction allowed to recover the cost or the basis of business or investment property having a useful life substantially beyond the tax year”. Depreciation allows you to recover the cost or the basis of certain property over the time you use the property.

Depreciation is essentially an allowance for the wear and tear, deterioration, or obsolescence of the property in question. Even if the property fails to yield any income, the property may still be depreciated.

What property may be Depreciated?

Depreciation may NOT be claimed on property held for personal purposes such as your personal residence, boat, or personal vehicle. These deductions may be claimed only for property used in your business or other income producing activity. If the property, such as your car for example, is used for both business and pleasure, only the business portion may be depreciated.

Depreciation Requirements for Real Estate

To be qualify, the income producing property must meet all of the following requirements:

  • It must be property you own.
  • It must be used in your business or income-producing activity.
  • It must have a determinable useful life.
  • It must be expected to last more than one year.

For a comprehensive explanation about the requirements for “Depreciation of Rental Property”,click here.

Land Is Not Depreciable

The heading says it all; you cannot depreciate land. As a rule, you can only “convert” the cost of land when you eventually sell it, at which point you will subtract the cost from the sales price to determine your taxable gain. So, when you purchase a rental property and the land on which the property is situated, the cost of the land must be subtracted from the total cost of the property. Only then can you determine depreciation expense for the property itself.

Although land is does not qualify, the cost of landscaping business property may be if the landscaping is so closely associated with a building that it would have to be destroyed if the building were replaced. Qualifying trees and bushes are depreciable over 15 years.

Depreciation Critical Facts To Understand

Three basic factors determine how much depreciation you can deduct. It’s critical that you understand these before reading the examples in the “General Depreciation Deductions” section.

First Year Allowances for Depreciation

The general rule is that a business can’t write off the whole cost of certain assets in one year. There are exceptions though:

General Depreciation Deductions

Recapture Depreciation

When you dispose of property that you depreciated using MACRS, any gain on the disposition generally is recaptured (included as income) as ordinary income up to the amount of the depreciation previously allowed or allowable. This includes any Section 179 deduction claimed on the property and any special depreciation allowance for Liberty Zone property.

To learn more about Depreciation Recapture, click here.

When Does Depreciation Begin and End?

You begin when you place the property in service for use for the production of income. You stop either when you have fully recovered your cost or other basis or when you retire it from service, whichever happens first.

Final Thought

Depreciation is a wonderful tax shelter for the small investor. The money you save today with the tax shelter can be invested to bring you to your financial goal much sooner. When in doubt, consult your accountant to discuss if you can use this tax benefit.

To learn about Rental Property Depreciation directly from the IRS, you can visit the IRS website.