Rental Property can be an effective tax shelter due to
Depreciation

Be sure to Depreciate your Rental Property because the IRS
assumes that you take it!  If you don't take the Depreciation,
you will have to pay taxes on the property when you sell it
through Depreciation Recapture!

You recover the cost of income producing rental property by
depreciating the property; that is deducting some of the cost on
your tax return each year.  The IRS acts as if residential real
property is losing value, or "depreciating".  Of course, the general
rule is that the property will increase in value, or "appreciate", over
time.  Depreciation is an accounting loss - it only shows up on
paper.

Factors to Determine Rental Property Depreciation
Three basic factors determine how much deprecation you may
deduct for your rental property:
 

Basis in the property   Recovery period for the property   Depreciation method used

You can deduct depreciation only on the part of your property used
for rental purposes.  If you rent a room in your house you can only
deduct a percentage of the depreciation available.  Visit our renting
a room section to learn more.  If you rent a rental property, you may
deduct the entire amount of depreciation available to you.  Depreciation
reduces your basis for figuring gain or loss on a later sale or
exchange.

Land Cannot be Depreciated
You can never depreciate the cost of land on your rental property
because land does not wear out, become obsolete, or get used up. 
The cost of clearing, grading, planting, and landscaping are usually
all part of the cost of land and cannot be depreciated.

Depreciation Recovery Period
For rental property, the depreciation cost is recovered over 27.5
years.  Only the cost of the structure is allowed as a depreciation
deduction; the value of land cannot be depreciated.  If the property
is used for commercial purposes, it must be depreciated over 39
years.

Example: Doug purchase a piece of rental property for $300,000.
The tax assessor for the county assessed the value of the land to
be $100,000 and the house to be $200,000.  The recovery period for
rental property is 27.5 years so Doug would divide the $200,000 by
27.5 resulting in $7272.73. 

Beginning of Depreciation Period
You begin to depreciate rental property when it is available for rent
to tenants.

Example 1:  You purchase a house in March 2007 and spent April
and May making repairs.  The house is ready to rent in June and
you begin advertising to find a tenant.  You may begin depreciation
as of June.  Even if a tenant doesn't move in for another two months
your start date is still June.

Example 2:  You bought a home and used it as your personal
home several years before you converted it to rental property.
Although its specific use was personal and no depreciation was
allowable, you placed the home in service when you began using
it as your home.  You can claim a depreciation deduction in the
year that you converted it to rental property because it's use
changed to an income-producing use at that time.

Adjusted Basis for Depreciation
Before you can figure the allowable depreciation, you may have to
make certain adjustments (increases and decreases) to the tax
basis of the property.  The result of these adjustments to the basis
is the adjusted basis.

Click here to learn more about the adjusted tax basis for your property


Depreciation Recapture for Rental Property
Depreciation on a rental property reduces your basis for figuring a
gain or loss on a later sale or exchange.  If you have a gain on the
sale of your rental property, part or all of the gain may be required to
be "recaptured" as ordinary income that is completely taxable in
the year of the sale.  Depreciation recapture is taxed at a rate of 25%.

Example:  Dan Bacon buys a rental property for $120,000.  Over time
he takes $25,000 in depreciation deductions.  These deductions reduce
his basis to $95,000 ($120,000 - $25,000).  In 2007, Dan sells his rental
property for $150,000.  Dan's gain is $55,000 ($150,000 - $95,000).  The gain
is comprised of two parts, $25,000 in depreciation deductions and $30,000
in excess of the purchase price.  The $25,000 is counted as part of
the taxable gain and taxed at a rate of 25%.

Note that the 25% tax rate is the maximum rate that can be taxed.  So, if
your personal income tax rate is 33%, for example, you are ahead 8%.

To learn more about depreciation recapture, visit our overview of
depreciation recapture.
 
Claiming the Correct Amount of Depreciation
You should claim the correct amount of depreciation each tax year. 
Even if you did not claim depreciation that you were entitled to deduct,
you must still reduce your basis in the property by the full amount of
depreciation that you could have deducted. 

Common Mistake
One common mistake some taxpayers make is that they do not
deduct depreciation on their investment property.  If you make this
mistake, correct it immediately by filing to take the past
depreciation with your current tax return.  You can amend your tax
returns for the previous there years so that you can depreciate your
properties on those returns (three years is the limit for amending
past returns).

If you are not allowed to make the correction on an amended return,
you can change your accounting method to claim the correct amount
of depreciation.  To change your accounting method, you must file
Form 3115, Application for Change in Accounting Method, to get the
consent of the IRS.  In some instances, that consent is automatic.  For
more information, see Changing Your Accounting Method in IRS Publication
946.

Important Note on Depreciation
If you don't take the depreciation when you should, the IRS will
assume that you took it anyway.  If you ever sell your investment
property, you will have to pay tax on the recaptured depreciation
even if there's nothing to recapture.  By not depreciating you will
lose the tax savings while you own the property and you will have
to pay taxes when you sell.

Section 179 Election
You cannot claim the section 179 deduction for property held to
product rental income.


For a comprehensive overview of rental property visit the rental
property section of real estate owner.



Click here to leave rental property depreciation and
return to depreciation main