≡ Menu

Tax Benefits of Depreciation for the Real Estate Investor

As we approach the end of the year, it is a time to reflect on the year, to celebrate the season, and for some of us, to begin a three and a half month long curse of the tax man. Even as many W-2 employees start to look forward to the largesse of “free money” in the form of a tax refund check, the self-employed and small business owners among us begin a low grumble that crescendos on April 14 into a full tirade on the evils of self-employment tax, and with all conviction, proclaim that tax withholding regulations tear at the very fabric of our Democracy.

I am among the latter.

But in the spirit of the season, we should attempt to focus on the things for which we are grateful, the blessings bestowed upon us. It is not to minimize the benefits of friends, family and the true blessings of life to say that I find comfort, in the context of these troubled thoughts of taxation, in losses. Preferably the tax kind.

For the real estate investor, rental property can provide substantial tax benefits through “tax losses.” In this article, I will provide an overview of how rental property provides tax savings through losses against ordinary income, reducing your tax bill now.

Income Tax on Rental Income

Rental income, like business income, is taxable net of expenses. In other words, the amount subject to tax is profits–gross rents less all ordinary and necessary expenses, such as maintenance and repair costs, property taxes, mortgage interest paid, and advertising costs.
The real tax benefit of rental property, however, is depreciation. While rental property will generally appreciate over time, for tax purposes, it is considered a depreciating asset. So, tax law provides for a depreciation deduction in calculating rental income or loss for rental property.

Calculating Depreciation for Rental Properties

Depreciation on residential real estate is calculated by dividing the cost of purchasing the home (price plus most closing costs) by 27.5 years. Since the costs of purchase generally includes land, which is a non-depreciable asset, the costs must be allocated between land and building based on the their fair market values. Typically, this allocation is made based on the tax assessed value of the property. For example, for a rental property with a cost of $100,000, assuming we allocate 80% of the costs to the home and 20% to the land, then the depreciation deduction would be $2909 ($80,000 divided by 27.5) per year. So if, for our $100,000 property, we have net income or profits before depreciation of $1500, we will still have a tax loss of $1409–a loss than can be deducted against ordinary income. Losses for tax purposes; profits for all others. That’s roughly where we were on The Ranch last year. Apply that across a few properties, and it starts to add up to real money.

As with all good things, certain limitations and restrictions apply. The deduction of losses against ordinary income starts to phase out for incomes in excess of $100,000, and the maximum deduction is $25,000 annually, although for real estate professionals (investors spending more than 500 hours annually in the biz) are not subject to the maximum deduction limit. Oh, and as is universally true of all things good, batteries are not included.

So, as I begin the process of closing out the financial year and preparing for the day of tax reckoning, it’s nice to know that I have at least the one tax advantage working for me. A thought that I can take comfort in as I sit in front of the Christmas tree wondering “Is there a way to write that off?”

Image Credit: GypsyRock

{ 16 comments… add one }

  • Meg December 19, 2007, 4:55 pm

    Thanks for the great article! I am in the process of purcashing my first investment property. Depreciation is the tax benefit that I know least about, so I appreciate the overview.

  • Mike-TWA December 20, 2007, 8:01 am

    Thanks, Meg. I’ll be interested to read more about your first buy.

  • Sods December 20, 2007, 2:41 pm

    I am from Canada, so I realize our Tax laws are vastly different. In Canada we have Depreciation Recapture, when you go to sell your property the value of the depreciation already taken in previous years is added back into income for the year, meaning you real estate tax deduction is really just a tax defferral. Do you not have anything like that in the USA?

  • Mike-TWA December 20, 2007, 4:48 pm

    Sods, Indeed we do have depreciation recapture, and the amount of gain representing prior years’ depreciation is subject to 25% depreciation recapture unless the sale is part of a like-kind exchange. But even if depreciation now is subject to depreciation recapture, the deferral of taxes itself represents some true gains.

  • Fixemup Terry December 21, 2007, 12:29 am

    Good article. Very informative. I like your easy-to-follow examples.

  • Sods December 21, 2007, 4:24 pm

    25% a year? that isn’t bad i guess, I would just be afraid to push myself into a higher tax bracket. I guess caution and planning are always the key in taxes.

  • Alex Morrow December 23, 2007, 2:34 am

    I would love it if you did a follow-up to this article that described what happens when you sell your properties that you previously depreciated for several years. Maybe include some ways to avoid the IRS from hitting you hard in texes!

  • TROY February 23, 2008, 10:50 am

    One way to get around the recapture fee is to never sell your rentals. Refinance them and let your kids take over the business.

  • Mike-TWA February 23, 2008, 11:41 am

    Troy, Great point.

    For the rest of our readers, check out this article that emphasizes the point:

    http://www.twowiseacres.com/2007/09/05/5-tax-free-ways-to-make-money-with-real-estate-investing/

  • Scottsdale Condos July 2, 2008, 1:04 pm

    Great post, I really enjoyed it. I will have to bookmark this site for later.

  • Cam August 20, 2009, 9:41 am

    Would like to know more on depreciation in Canada. I run a business that prepars depreciation schedules in Australia based on a quantity surveyor’s estimate of the building construction costs. Generally the depn rate is then taken over 40yrs @2.5%. Depreciation is recaptured when the property is sold however this is generally reduced by 50% via capital gains tax if you keep the property for more than a year and if you live in the property and then sell your capital gains tax is nil (hence no depn recapture) as it is no longer an investment property. Interested in the Canada situation as am moving there? Also Plant items like stoves, Air conditioners are depreciated at higher rates. Is this the same for Canada?

  • Motivated Sellers August 14, 2010, 4:01 pm

    This is a great post on the tax benefits of depreciation. Too bad they don’t let you deduct the depreciation expense for your personal residence.

  • Kyle Koller December 14, 2010, 12:34 pm

    TWA,

    I have two questions that I was hoping you could answer:

    1.) As a passive investor making <$100K, can you apply your real estate income losses against your ordinary income, or just the left-over unused depreciation?
    2.)Where do you write this income off on your 1040?

    Your article was great and I definitely enjoyed reading it. I hope to hear back from you soon.

    Kyle

  • Mike January 29, 2011, 5:01 pm

    Kyle,

    The short answer to 1) is maybe. Generally, passive losses can only offset passive income. However, with rental real estate, if you “actively participate” in the investment, you can deduct up to $25,000 in losses against ordinary income if you make less than $100,000. Active participation doesn’t necessarily mean that you pull up the old carpet when the tenant moves out. You can still delegate many tasks to a manager and qualify as actively participating if you are involved in major decisions concerning the rental property.

    Income and loss (including depreciation expense) will be reported on schedule E and carryover to line 17 on your 1040.

    Happy deducting!

  • Larry March 21, 2011, 11:39 am

    So if I find myself in the income range where I lose my ability to deduct rental losses, am I still going to get hit for the depreciation shown on my tax return this year when I eventually sell the property even though I couldn’t actually get any benefit from the depreciation due to the loss limit?

  • Dawn May 29, 2011, 4:20 pm

    Selling my business for 300,000. My accountant has it depreciated down to 90,000…………HOw bad will I be hit with taxes, and isn’t there away around any of this.
    I realize that a real estate exchange is what is usally done but for me it isn’t an option. This business has put me 98,000 in credit card debt so to pay this depreciaon tax sems ludicris

Leave a Comment