Real estate investing provides many tax benefits, and depreciation is one of the biggest. It’s also one of the more misunderstood.
Depreciation lets you deduct a portion of the cost of the investment each year for the length of its IRS-designated life span. The depreciation computation is figured based on the value of the improvements, not on the land underneath the improvements. This necessitates that you be able to determine the value of the land and the value of the improvements. This determination is generally included in the multitude of closing documents you received when buying the property or found on the county real estate tax website. It is essential that you keep your closing documents. There are additional costs that can be expensed and loan costs that must be amortized involved in the closing itself.
A recent client case provides a good example for this deduction and how it can be forgotten.
Joe, an old Army buddy into my office asking for help with his taxes. He had done his taxes up to this point as he had a pretty simple tax situation but about two years ago he moved and turned his old primary home into a rental property. The first year of owning his home he had done his taxes and he had read some articles about depreciation and expenses that had gotten him thinking that maybe he had done something wrong on his taxes so the following year when his taxes were due he came to me make sure everything was correct.
I reviewed his prior year tax return and immediately knew I was going to have to file an amendment to correct some glaring mistakes. The first thing I looked at was his Schedule E. He had about $10,000 of rental income and no expenses. He had a 1099 showing interest and taxes for the property. He had mistakenly included all the interest and taxes from the 1099 as an itemized expense and had not prorated the amounts between schedule A and E. That was pretty simple. When I computed his mistake, he had taken the standard deduction so the decreased itemized amount did not negatively affect him but I when I added up the interest and taxes attributable to the rental portion of of the property it reduced his income down to about $7,000.
Next I took a look at his depreciation. Which was pretty quick because he hadn’t taken any. IRS tax rules state that any depreciation recapture is computed on the amount that was take or the amount that should have been taken. So, since the IRS requires the computation of depreciation recapture whether or not you actually took it, it makes sense to take the deduction when you can. Figuring depreciation requires the computation of a basis of the property. Generally, for someone buying a property as an investment property, their basis would be the purchase price of the improvements, not the land, minus buying costs plus amounts spent on capital improvements. In the case of converting a primary property to a rental property this computation is a little more complicated. It is the lesser of the adjusted basis or the fair market value at the time of conversion.
In my friend’s case he had paid $250,000 for his home. $50,000 of which was for land costs. He also paid about $3,000 in closing costs and had made no capital improvements to the property. This gave him a basis in the property of $197,000. On the date he left the property and turned it into a rental it was estimated to be worth about $350,000 of which $300,000 was attributable to land value. That $300,000 is divided by 330 to get a monthly depreciation amount of $909. 330 is the length of time in months the IRS says to depreciate residential real estate over. The property had been turned into a rental for the last 5 months of the year. This lead to a total cost of $4,545 that could be apportioned to depreciation, bringing his income from the rental property down to $2,455.
Then I talked with him some more. He had paid rental property management fees of about $1,000, a homeowner’s fee is $600 and had other miscellaneous expense related to his property totaling $400. All these expenses totaled about $2,000, leaving about $455 of income from the rental property.
I sat down and showed him all this. Of course he asked me so what is the difference? And so I laid it out for him. Before I corrected his taxes he had a taxable income of of about $110,000 after his taxable income was about $100,000. He was in the 28% tax bracket, by reducing his taxable income by the $10,000 we had reduced his prior year tax bill by about $2,800. We filed an amended 1040X and got his money back.
Carefully accounting for costs when it comes to rental property and other deductions that you may be eligible for is key. Knowing how those costs and deductions are computed and how to deduct them is essential in ensuring you make the most of your rental property.
Scott Vance is a fee-only planner and Enrolled Agent at Taxvanta serving the Raleigh, N.C. area. He recently retired from the Army. His background allows him to uniquely understand issues faced by military personnel, but he works with all clients. He is currently a candidate for CFP® certification and seeks to provide objective, commission free advice to clients. Vance was born and raised in Pennsylvania. He is married to Amy. They have a son, Brandon. They enjoy skiing and kayaking. He can be reached by email at scott@taxvanta.com
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