Depreciation is an accountancy concept and it is applicable on all tangible assets. It shows how, over time, the money value of the asset reduces. In the case of real estate, the building that you rent out, will, over the years reduce in value because it will wear out and many parts of the building may become entirely obsolete. The IRS has a way to calculate depreciation that will allow you to save on taxes. When the value of the property comes down, the income drawn from it will also logically reduce (even if it doesn’t in real money terms), which gives the property owner a small reduction in income taxes annually.
How it works
The IRS has published a list of guidelines that need to be adhered to before you can deduct depreciation from the yearly tax filing.
- You have to be the owner of the property
- The property is used to generate income through rentals or otherwise
- The total useful life of the property is calculable
- The property should last for over a year minimum
Depreciation begins when the property or asset is put into service and ends when it is taken out.
Calculation of depreciation
For residential rentals, the method is as follows:
First the building value of the property has to determined:
Building Value (BV) = Purchase price of the property – Value of the land
Using the building value, depreciation can be found:
BV/ 27.5 = Annual depreciation allowed in dollars
The 27.5 is significant as that is the total number of years specified by the IRS to calculate depreciation for residential rental properties.
There are exceptions to depreciation and the two most important ones are land and ‘Excepted’ property like temporary structures and equipment used to increase capital value of the structure.