You may have heard that investing in real estate comes with big tax advantages. It's true. Specifically, the ability to use depreciation rules on real estate assets can dramatically reduce an investor's taxable income. In many cases it can even eliminate income taxes entirely.
When it comes to a property, the IRS has set 27.5 years of useful life as the depreciation period for residential real estate.
Property Value: What is the appropriate number to use for the property's beginning value?
When you bought the property, what price did you pay for it?
Since this is literally the price that was paid for the property, this could also be a reasonable number to use when determining the market value of the property and ultimately, the depreciation amount.
Which Property Is Depreciable?
According to the IRS, you can depreciate a rental property if it meets all of these requirements:
- You own the property (you are considered to be the owner even if the property is subject to a debt).
- You use the property as an income-producing activity.
- The property has a determinable useful life, meaning it's something that wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes.
- The property is expected to last for more than one year.
Even if the property meets all of the above requirements, it cannot be depreciated if you placed it in service and disposed of it (or no longer use it for income) in the same year.
Warning: you must subtract the land value from the amount you depreciate.
Using the Assessor's Opinion of Land Value
If we continue on this path of using the local assessor's opinion of the property's land value, we can use their percentages to come up with the right depreciable amount.
- Tom bought the rental home for $160,000
- Tom's Improvements were: $30,000
- Land value: $24,000
- Total Value: $166,000 (100%)
Total value is divided by 27.5 years which is your depreciation amount.
Example from above:
$166.00 divided by 27.5 equals $6036.36
There are special rules relating to the rental of real property that you also use as your main home or your vacation home. For information on income from these rentals, or from renting at an amount less than the fair market value, refer to Topic No. 415.
If you don't use the rental property as a home and you're renting to make a profit, your deductible rental expenses can be more than your gross rental income, subject to certain limits. For information on these limitations, refer to Publication 925, Passive Activity and At-Risk Rules and Topic No. 425.
Make Sure You Don't Disqualify for Tax Deductions!
Do Not Rent to Family or Friends
If you're thinking of renting to friends or family, think twice as this will automatically disqualify you from almost all tax deductions.
Keep Good Records of Expenses
One of the biggest challenges real estate investors face is keeping good, consistent records of expenses
throughout the year. Failure to keep good records will make it much more difficult to claim deductions come tax season.
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