Rental properties have a finite useful life, which means they will eventually be obsolete and require replacement. If you use a rental property for rental purposes, you can write off the cost of the property over the years based on its useful life. This deduction, called depreciation, can save you money on taxes each year.
Depreciation is the reduction in the value of an asset over time and can be used to recover its cost faster. As rental properties are long-term investments that only have a finite useful life, they can qualify for accelerated depreciation in the first few years by choosing one of several available options. This reduces your taxable income and saves you money on your taxes.
Yet calculating and tracking rental depreciation isn’t easy. And that’s why so many landlords get stuck with big tax bills at the end of every year.
Fortunately, plenty of ways to ease this burden and reduce your tax liability. Here are some examples of depreciation strategies that might work for you.
Repairs and Maintenance
If your rental property requires some repairs, you can deduct the cost from your rental income. Generally, you must use the “repair” method of accounting, which allows you to deduct the entire amount of repairs when you make them, regardless of how long they last.
To illustrate, suppose your roof needs $2,000 worth of repairs. This can be deducted from your rental income. However, the roof will eventually need replacement, and you cannot remove the cost of the roof again.
If you have significant repairs that will extend the life of your property, you can deduct these as capital expenditures. Depending on the nature of the work, you might be able to deduct an amount each year or depreciate the entire amount over several years.
If you want to increase the rental value of your property, you can deduct the cost of renovations from the rental income. Most likely, you will have to use the “depreciable cost” method of accounting, which means that you cannot deduct the full cost of the renovation in the year you make the investment but have to depreciate it over a number of years.
Depending on the nature of the renovations and your expected return on investment, you might be able to take a deduction for the entire cost in one year or be able to depreciate a portion of the cost over several years. If you use the cost method of accounting, you can deduct the full amount of renovations when you make them.
However, you must add the amount to your rental property’s depreciable basis, which will reduce the amount you can deduct in later years.
Depreciation of Building or Repairs After a Loss
If you suffer a loss due to a fire, flood, or other cause, you can use the “repair or replace” method to deduct the cost of repairs or a new building. Many landlords use this method to deduct the full amount of repairs or new construction in the year of the loss, and then they depreciate the building over the remaining useful life of the property.
Depending on the amount of the loss, it might be advantageous to use the “straight-line” method of depreciation, which is a more conservative approach than the “sum-of-the-years’-digits” method. The straight-line method spreads the deduction over a number of years, while the sum-of-the-years’-digits method is more aggressive.
Our Final Thoughts
Depreciation strategies vary, depending on the expected useful life of the property, the expected rate of return on the property, and the expected rate of inflation.
However, regardless of which depreciation strategy you choose, you can only take a deduction in the year you make the capital expenditure that improves the property. You cannot take a deduction for depreciation in the year you purchase the property or complete renovations.
Note that you can only deduct expenses that are part of rental or business operations. You cannot deduct personal or home improvement costs or expenses for rentals that you do not claim as a business.