Owning and maintaining a rental property can be expensive — not to mention a lot of work. Luckily, some of the expenses are deductible and claiming depreciation helps defray the cost of property ownership. Depreciation is a deduction that allows the investor to recoup the cost of assets (in this case, the rental property) used as a source of income.
Whether or not you choose to take depreciation doesn't matter to the IRS. When you sell a property, the IRS levies a fee on the depreciation you should have claimed.
What is Depreciation?
According to the IRS, “depreciation is the recovery of the cost of the property over time. You deduct a part of the cost annually until you fully recover its cost." The IRS considers that real estate and other physical assets wear down over time.
You can’t fully recover the entire cost of the rental property in a single year, which is why you spread the deduction over the useful life of the asset to match annual wear and tear. You can depreciate a rental property if it meets these requirements:
- You are the property owner
- The property is used for business or income-producing purposes
- The property has a determinable useful life, meaning it wears out over time
- The property is expected to last longer than a year
Land cannot be depreciated because it cannot wear down over time. Land costs include clearing, grading, planting, and landscaping.
Rental Property Depreciation
According to the IRS, the expected useful life of a rental property is 27.5 years. Therefore, each year, you can deduct 3.636% (100% / 27.5 years) of the rental property's cost basis from your annual income. This deduction reduces the amount of income subject to taxation.
This IRS allows you to depreciate some repairs and improvements made to the property in fewer than 27.5 years. For example, appliances may be depreciated over five years, office furniture and equipment over seven years, and roads and fences over 15 years.
After 27.5 years, the entire cost basis has been deducted, and depreciation ends. Depreciation can also stop after the property is sold or the rental property stops producing income.
What happens if you don't depreciate your rental property?
Rental property depreciation can be a considerable tax advantage for investors. For example, suppose your rental property produces $8,000 in annual income after all expenses. A $3,000 depreciation expense reduces the property's taxable income to $5,000. Some investors may be tempted to skip claiming depreciation to avoid the risk of depreciation recapture tax, but this generally won’t succeed.
The IRS assumes that you have taken a depreciation deduction. You will owe 25 percent of what you could have deducted as a “depreciation recapture” when you sell the property. That amount is due whether you take a deduction or not.
If you haven't claimed depreciation on your tax return, you can amend your recent tax return to claim your depreciation benefit. To do this, file an amended return by filling out Form 1040X and other forms you're modifying. For depreciation deductions, use Schedule E.
Are There Other Ways to Shelter Capital Gains from Tax?
Gains are the goal, and taxes are a part of the process. However, savvy investors look for ways to manage and favorably schedule their tax payments. For example, holding property in a tax-advantaged trust can be feasible, but the tactic may sometimes limit control. Having some assets in a retirement account may allow the investor to defer taxes until they are in a lower bracket. Also, an investor may be able to delay capital gains taxes by using a 1031 exchange to execute the transaction when selling a property and reinvesting in another. Finally, there is still potential for deferral and tax reduction by directing capital to a QOF (Qualified Opportunity Fund) project. Make sure to seek professional advice on these options.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Hypothetical examples shown are for illustrative purposes only.
Costs associated with a 1031 transaction may impact investor's returns and may outweigh the tax benefits. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
The income stream and depreciation schedule for any investment property may affect the property owner's income bracket and/or tax status. An unfavorable tax ruling may cancel deferral of capital gains and result in immediate tax liabilities.
FAQs
File an amended return: This only works if you didn't deduct depreciation on your rental assets for one year. Go back and amend the return to reflect the missed depreciation. Note: You can only go back one year to claim a possible refund for missed depreciation.
Is it mandatory to claim depreciation on rental property? ›
Whether or not you choose to take depreciation doesn't matter to the IRS. When you sell a property, the IRS levies a fee on the depreciation you should have claimed.
What happens if you don't depreciate? ›
IRS Code Section 1250 states that depreciation must be recaptured if it is allowable for the property. So, even if you don't claim depreciation for the years you owned the property, you'll still have to pay tax on the gain when you decide to sell.
Can you choose not to depreciate an asset? ›
Claiming Large Asset Expenses
Instead, you need to depreciate it over time. This rule applies whether you use cash or accrual-based accounting. If you elect to not claim depreciation, you forgo the deduction for that asset purchase.
Can I claim missed depreciation? ›
Form 3115, Change in Accounting Method, is used to correct most other depreciation errors, including the omission of depreciation. If you forget to take depreciation on an asset, the IRS treats this as the adoption of an incorrect method of accounting, which may only be corrected by filing Form 3115.
Can you skip a year of depreciation? ›
Depreciation is a non-cash expense, meaning you don't actually spend money when you claim it on your tax return. However, it reduces your taxable income, which in turn lowers your overall tax liability. If you skip claiming depreciation, your taxable income will be higher, and you may owe more in taxes.
What is the downside of depreciation rental property? ›
Your cost basis is essentially reduced by the amount of accumulated depreciation, increasing your subsequent gain on sale. Since you deducted depreciation as an expense every year during ownership, you cannot deduct the original cost from your sale price to reach your taxable gain on sale. This would be double-dipping.
How do you avoid depreciation on a rental property? ›
How to Avoid Depreciation Tax on Rental Property
- Conduct a 1031 exchange. This is a strategy that allows you to defer paying capital gains tax on the sale of an investment property – provided you use the revenue earned to purchase another similar property. ...
- Pass on the property to your heirs. ...
- Sell the property at a loss.
Depreciation is mandatory. The insertion of Expln 5 to s. 32(1) is to be applied prospectively and it clearly takes away the right of choice of the assessee to make a claim for depreciation or not. It would be open to the ITO to grant depreciation even if the assessee had not furnished the prescribed particulars.
Is claiming depreciation worth it? ›
Depreciation can also help investors maximize their gains on any given piece of property while also minimizing out-of-pocket expenses. These tax benefits may factor heavily into your decision to invest.
If depreciation is not charged, the unexpired cost of the asset concerned would be overstated.
When you sell a rental property, do you have to pay back depreciation? ›
Depreciation expense taken by a real estate investor is recaptured when the property is sold. Depreciation recapture is taxed at an investor's ordinary income tax rate, up to a maximum of 25%. Remaining profits from the sale of a rental property are taxed at the capital gains tax rate of 0%, 15%, or 20%.
Am I required to take depreciation on rental property? ›
In short, you are not legally required to depreciate rental property. However, choosing not to depreciate rental property is a massive financial mistake. It's the equivalent of pouring a percentage of your rental property profits down the drain. This is not an exaggeration.
Is it better to deduct or depreciate? ›
Expensing an item may bring in more money in the short term, but once you have expensed it, it does not qualify for write-offs on future tax returns. Depreciating an asset may result in less money upfront, but could result in fewer taxes owed in the future.
What happens if depreciation is not recorded? ›
If depreciation expense is not recorded, the cost of fixed assets is not considered in setting sales prices, and established prices may not be high enough to cover the cost of fixed assets.
How do I claim depreciation on my rental property from previous years? ›
What IRS forms do I file in order to claim depreciation? To claim rental property depreciation, you'll file IRS Form 4562 to get your deduction. Review the instructions for Form 4562 if you're filing your tax return on your own or consult a qualified financial advisor or tax accountant for assistance.
What if depreciation is not claimed? ›
By opting out of claiming depreciation for a particular year, the profits of the assessee would be that much higher; enabling the set off of carry forward business losses which might otherwise lapse.
Can you restart depreciation on a rental property? ›
Yes. When you take residential rental real estate out of service and then place it in back in service, your recovery period (27.5 years) starts over. Of course, generally, your basis for depreciation will be reduced.
Can I delay depreciation? ›
There are times you may want to defer the start of depreciation expenses to a later period. For example, when you are constructing an asset internally and can only start depreciating the asset once it is fully ready for use.
