Depreciation is a tax strategy that can be used to take off a part of the cost of some company and investment assets, including rental property.
It helps lower the amount of income that is to be taxed. Depreciation is taxable income while an investment is held, but it is recovered and taxed whenever it is unloaded.
Here, we’ll go through the rental property depreciation recapture and other strategies for keeping more of your hard-earned money after selling an investment property.
What is depreciation recapture for a rental property?
When an investment property is sold, the depreciation that was written in the past can be recovered. The procedure by which the IRS recovers the advantages you got when you used the depreciation expense to lower your tax liability is known as “recapturing depreciation.” It involves taxing the gain you generated from your income-generating asset and collecting taxes on it.
Knowing how to depreciate rental property
Let’s take a moment to review how and why depreciation happens the first time. That will set the stage for our discussion on how rental property depreciation is recaptured.
One of the most significant advantages of real estate investment is that the Internal Revenue Service (IRS) enables you to depreciate the property for every year you possess it, up to a maximum of 27.5 years for home rental property.
For federal income tax purposes, depreciation is an allowable expense provided that perhaps the property involved (but not the land beneath it) deteriorates over time.
What Happens When a Rental Property Depreciates?
It is not the current worth of a property that is used in the calculation of depreciation; rather, the baseline of the property’s cost is used.
After deducting the cost of the land from the total purchase price (because land doesn’t depreciate), improvements made to the house, plus some qualifying closing charges, are added together to arrive at the cost basis.
Taxes on real estate, registering and title fees, and any liabilities you take on the lender’s behalf are considered qualified closure costs.
Then, at the end of the IRS-mandated recovery phase, you can deduct the entire cost basis. Currently, the amount of time needed to recover costs on a residential rental property is 27.5 years, which is roughly 3.636% each year (100%/27.5).
It follows that a costlier basis allows for a larger deduction. This 27.5-year number is a rough guess used as a standard in financial reporting since it represents the life span of a given asset.
As a result, you might take a larger deduction than the property really depreciates, leading the Internal Revenue Service to try to get back part of your cash.
Final words
When it comes to investing in rental property, depreciation is a powerful instrument that may allow investors to spend dozens or even hundreds of thousands of dollars on the property.
It’s important to take deductions where they’re warranted, but you shouldn’t go crazy with them. To be sure, the IRS is being kind to investors by providing them with this deduction.
