Rental property depreciation represents one of the single greatest tax benefits made available to today’s real estate investors. The ability to offset some—if not all—of your rental income is a critical component to building wealth over an extended period of time. However, as with just about any other tax related strategy, there are several questions that need to be answered before any claims are made. Likewise, be sure to consult a tax professional before you even consider deducting rental property depreciation from your own taxable wages.
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The government has acknowledged that buy and hold investors depend on their real estate assets to produce income, and have come up with a way to compensate them for the inevitable deterioration of their homes. As a result, the depreciation process associated with rental properties works a lot like a standard business depreciation expenses. Whereas qualifying business expenses allow entrepreneurs to deduct from their taxable income each year, rental property depreciation allows real estate investors with rental properties “in service” to do the same—only on a larger scale.
Rental property owners are permitted by the Internal Revenue Service (IRS) to deduct (write-off) the cost of purchasing a home. However, the entire cost of the rental property may not be deducted in a single year, but rather over the course of 27.5 years (the amount of time the IRS has determined to be an appropriate life span of single-family homes). That means rental property owners can deduct a portion of the home’s purchase price each year until the basis has been accounted or the 27.5 year time limit is reached.
Rental property owners who have a modified adjusted gross income of $100,000 or less are permitted by the IRS to deduct up to $25,000 in rental real estate losses each year their property is in service (they actively participate in rental activity). However, the $25,000 allowance is tapered for those who’s modified adjusted gross income is higher than the previously discussed $100,000 threshold. Meanwhile, those with a modified adjusted gross income of more than $150,000 aren’t extended the allowance at all. Consequently, the same rules don’t apply to real estate professionals. Rental property owners who are real estate professionals in the eyes of the IRS are allowed to deduct any amount of losses from their other non-passive income.
Depreciation can offset rental income for qualifying rental property owners, but the amount of rental income offset can’t exceed the amount claimed for depreciation. More specifically, the rent collected from a rental property qualifies as income in the eyes of the IRS—that means it is added to your taxable income each year. However, the IRS will allow the amount claimed in rental property depreciation to deduct from the total taxable income of a rental property owner. In other words, you may offset rental income and lower your taxable income by deducting several rental expenses, not the least of which is depreciation. If, for example, you make $10,000 in rent and claim $5,000 in depreciation for the year, you may offset half of the rental income. If you have other rental expenses, however, they may offset the income even further.
Rental property depreciation is currently recognized as one of today’s greatest tax shelters. The ability to deduct a property’s entire acquisition costs over the course of 27.5 years can significantly reduce tax liabilities in a way few other things can. That said, there are things investors need to know, like tax deduction income limits, before they rely on rental property depreciation. At the very least, the more you know about each and every tax benefit, the more likely you are to turn tax season into a time of the year you look forward to.