Depreciation of Rental Property

Assets and properties are important terminologies in the world of investments and finance. They give you a financial security. But every materialistic entity undergoes wear and tear. So do the buildings and structures, which are a part of your rental properties. A steady drop in the rental property value over the years is known as rental property depreciation.

What Is Depreciation of Rental Property?

Definition: Depreciation of rental property can be defined as the steady rate of decrease in the value of a passive rental property owned by a person.

Rent collected on property is also a source of income. But is that a part of the taxable income? Yes! But then the depreciation costs, repairs and operating costs are considerable amount of tax deductions that can be made on the taxable rental income. For investors, depreciation of rental property is a good news, as the taxable portion of income from the property is recovered through the rental depreciation. As per the Internal Revenue Services (IRS), the factors that determine the amount of rental depreciation are: the recovery period for the property owned, the owner's claim on the property and the kind of depreciation methods used. Not to miss on an important point, the rental depreciation applies only to the structures and rental properties on a land and not to land.

Rental depreciation is favorable investment choice when it comes to real estates and rental properties. To avail the benefits of rental property depreciation, many investors allocate much of their property purchase price to improvements and little to land. For example: A tax assessor has shown on paper that he has 95% of his property that is attributable to improvements and 5% to land. This is accepted by IRS, although the distribution by the tax assessor may not be actual. When a property is shown attributable to improvements, the depreciation costs are deductible expenses, which provide an effective tax shelter for rental properties. Let's take an instance. Assume there is a property which has cash flow worth USD 5000. Say, the cash income is exceeding the cash expenditures annually by USD 5000. Now the investor has USD 5000 cash in hand. If this were depreciated as USD 10,000 in that financial year, the property would have suffered a loss of USD 5000. But if it is shown as USD 5000, the spendable income would remain untaxed and the remaining USD 5000 (depreciation cost) would be used to offset other incomes. This is how rental depreciation helps in tax sheltering.

How to Calculate Rental Depreciation?
Let's take a look at the method to calculate rental property depreciation, on an annual basis:

Annual depreciation = (Purchase price - Cost of the land) / Life span

where:
Annual depreciation: is the amount of expenses that can be claimed on a yearly basis.
Purchase price: is total price that has been paid for the rental property.
Life span: is the number of useful years for the rental property.

Let's take an example: John has bought a rental property worth USD 250,000. The land value is USD 50,000. The residential property is depreciated over 20 years. So, what would be the depreciation of the rental property owned by John?

Going by the above formula,
Annual Depreciation = (250,000 - 50,000) / 20 = 200,000 / 20 = USD 1000

Nowadays, there are many property management software available, which can be of immense help when calculating rental depreciation for multiple rental properties.