If you didn’t catch the first part of the TwoWiseAcres quick and dirty guide to taxes for the real estate investor, you might want to check it out. In the first part, I walked through reporting income and expenses for rental properties on Schedule E. In this part, I’m going to cover the basics of depreciation. I’m going to focus on calculating depreciation for the first year of a new investment purchase, but I’ll touch on depreciating capital expenditures incurred later on as well.
If you followed my advice in part one, you should now be well rested and/or liquored up. So, once again, let’s get busy.
Starting to Depreciate a Residential Rental Investment
Depreciation is essentially recovering the cost of an item (or “expensing” an item) over a number of years. To determine depreciation for tax purposes, you have to know three things: the basis, your start date for depreciation, and the depreciation period for the property.
Basis is generally cost. For a rental property, the cost includes a portion of the purchase price, expenses associated with the purchase (i.e. closing costs), and initial rehab or fix-up costs. The “portion” of the purchase price is the portion attributable to the house, and not the land. Since land is not depreciable, you’re required to divide the purchase price between the land and the building by their fair market values. There are a couple of ways to tackle this. First, you can base the allocation of the purchase price between land and building based on the assessed value for property tax purposes. For most, this means that you can go to your county auditor website which will assign a separate taxable value for the land and building and then use the percentage allocation used by the auditor to allocate your purchase price. Second, you can make your own fair market determination, as long as there’s a basis to do so. I use a standard percentage division between land and building of 20% and 80%, respectively, which I pretty much came up with from looking at assessed values to begin with. For those starting out, you’ll want to refer to the tax assessed values for your area rather than just adopt my percentage split.
Depreciating Closing Costs
For the closing costs component, you’ll probably need to refer to your Settlement Statement (or “HUD-1 Form”), but you’ll need to exclude any “pre-paids” that are typically listed as buyer’s expenses, such as pre-paid interest, property taxes, and insurance. Those items will generally be reported as expenses for the year of purchase, so they are not included in the cost basis of the property.
Depreciating Initial Rehab Costs
Fix-up costs include every expense that you incur to put the property in rent-ready condition. This is going to include items spent during the initial fix-up period that might otherwise be treated as current deductible expense items down the road. For example, your rehab will likely involve interior painting, which has to be treated as part of the basis of the property at the outset, but which would be fully deducted in the current year when you re-paint, say, at the time a tenant leaves. Why? Well, that’s what the tax code says.
Determining the Start Date for Depreciation of Rental Property
So now you’ve calculated the basis—i.e. the amount that you’re going to depreciate–now you need a start date. You start depreciating a rental property not when you buy it, but when the property is rent-ready. There’s a little bit of a judgment call here. If you buy it in January, but you’re doing a major rehab into March, then depreciation starts in March. But I almost always find that I have some punch out repairs that might even extend after the property has been rented. So, I’m generally going to pick a start date right around when I can show or advertise the property as a finished product.
For the start date, you actually just need a start month. The IRS helpfully has determined the day during the month that depreciation begins. It’s the 15th. The story goes that the IRS had originally started drafting a complicated set of rules to narrow the start date right down to the day, but got tired and ended up with the 15th, collectively reasoning “close enough.” Now, I could use some fancy IRS terminology like “mid-month convention”, but I’m going to just repeat—it’s the 15th. So if you finish your rehab on March 2, you’re depreciation start date is March 15. Close enough.
Determining the Depreciation or Cost Recovery Period for Rental Property
The last piece in the depreciation puzzle is the depreciation period (or “cost recovery” period in IRS parlance). Here’s where the IRS starts with its explanation:
MACRS consists of two systems that determine how you depreciate your property—the General Depreciation System (GDS) and the Alternative Depreciation System (ADS).
Since the whole purpose of this article is specifically not to use terms like “Modified Accelerated Cost Recovery System,” I’ll just cut to the chase. For the most part, two periods will be applicable to about any depreciable property for residential real estate investing. The first is the depreciation period for the house itself. It’s 27.5 years. This depreciation period also applies to about any major depreciable item that you attach to the house—such as a roof, a major kitchen remodel, window replacement, etc. Then there’s the period that applies to about anything that you put in the house. It’s 5 years. This applies to things like kitchen appliances, carpet, and furniture.
The Depreciation Calculation—the Straight Line Method
Now we have all of the necessary information to do the math. For most, depreciation will be calculated using the straight-line method—which means the depreciation deduction for each full year of depreciation period will be the same. To calculate a year’s depreciation, you divide the cost by the depreciation period. For the year that you start depreciating (as well as the last, when you sell it), you’ll be calculating depreciation based on the partial year. Let’s take our example of the property that was ready for rental on March 2 and assume that the cost including rehab is $100,000.
The annual depreciation amount is $100,000 divided by the depreciation period of 27.5 years which equals $3636.36. For the first partial year, the depreciation amount is calculated for 8 full months plus ½ month for March (if you didn’t catch it before—our start date is the 15th). The calculation is 8.5 months divided by 12 months times the annual depreciation of $3636.36 which equals $2575.76. If you bought some appliances for the home, the calculation is essentially the same but using a 5 year period to determine the annual depreciation.
The depreciation deduction for subsequent years, until the year of sale, will be the annual depreciation amount each year. In the year of sale, the partial year’s depreciation calculation will be the same as the first year’s. That is, you’ll figure the partial year’s depreciation up until the date of sale, but will treat the sale as occurring on the 15th day of the month in which the property was sold. Again, close enough.
Depreciating Capital Expenditures for Rental Property
If you incur a capital expenditure after the year of purchase, such as replacing a roof, the expenditure will be depreciated as a separate item. In other words, for tax reporting purposes, you’ll separately depreciate the roof over a 27.5 year period, calculating depreciation in the same way as you calculated depreciation of the home itself, including using a start date of the 15th day of the month in which the roof was installed.
As a final note, I’ll point out that there are alternatives to using a straight line method of depreciation and alternatives to using the depreciation periods referenced above. Different rules may also apply to property purchased prior to 1986. But this, my friends, is where I hop off the train. If you need more information on depreciation or alternatives available, a tax advisor may be in order. In the meantime, I’ll just wish you all a happy tax freedom day, which I believe falls somewhere in late April these days. Here’s hoping that taking advantage of some depreciation deductions will move it a bit earlier.