Capital gains and how they are taxed
In the eyes of the IRS, almost everything has a useful lifespan—even your property. While the actual land your property is on might last forever, buildings and structures won't. Over time, wear and tear from use, weather, and aging will have an effect. Depreciation is the method by which the IRS allows property owners to account for that inevitable decline in value.
How Depreciation Works for Tax Purposes
Calculating Depreciation: The first thing you need to know is that only the value of the building can be depreciated, not the land. If you purchase a property for $500,000 and an appraisal determines the value of the building to be $400,000 and the land to be $100,000, only the $400,000 is depreciable.
Deducting Depreciation: Each year, you can deduct the calculated depreciation from your taxable income. So, if you earned $50,000 from renting out your property, you'd subtract the $14,545.45 from that amount. This means you'd only pay tax on $35,454.55 of your rental income for the year.
Benefits of Depreciation:
Reduced Taxable Income: As shown in the example above, depreciation directly reduces your taxable income, potentially placing you in a lower tax bracket and definitely reducing your tax liability.
Increased Cash Flow: By reducing your taxable income, you get to keep more of the rental income you earn, which can be reinvested or used to enhance your lifestyle.
Flexibility: If you incur a loss on your property after accounting for expenses and depreciation, and you're a real estate professional, you might be able to offset other income with this loss. This can provide even more tax advantages.
A Few Things to Keep in Mind:
Depreciation Recapture: When you eventually sell your property, the IRS will want to tax you on the amount you've claimed in depreciation over the years. This is known as "depreciation recapture". However, there are strategies, like the 1031 exchange, to defer this tax.
Improvements vs. Repairs: If you make improvements to your property (like adding a new room), this can be depreciated as well. However, simple repairs (like fixing a leaky faucet) cannot be.
Consult a Professional: Tax codes and regulations can be complex. It's always a good idea to work with a tax professional to ensure you're taking full advantage of the benefits while staying compliant.
In essence, depreciation is a way the tax system acknowledges that property wears out over time. For property owners, it's a valuable benefit that can lead to significant tax savings year after year.