When it comes to managing rental properties, understanding the concept of depreciation is essential for both tax planning and investment purposes. Depreciation allows landlords to recover the costs of their property over its useful life and reduce taxable income. This article will cover the basics of calculating depreciation for rental property, including the Modified Accelerated Cost Recovery System (MACRS), and a step-by-step guide to get you started.

Step 1: Determine your property’s basis

The basis of a rental property is its cost, including the purchase price, settlement or closing costs, and any expenses incurred in acquiring the property. Any improvements made to the property that add value can also be included in the basis. Remember that land value is not depreciable, so it should be separated from the building’s cost.

Step 2: Determine your property’s recovery period

According to IRS guidelines, residential rental properties are to be depreciated over a recovery period of 27.5 years using the MACRS method. In contrast, commercial rental properties have a recovery period of 39 years.

Step 3: Choose a depreciation method

The MACRS system utilizes two different methods for calculating depreciation – the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). GDS is commonly used for residential rental properties and employs declining balance method over 27.5 years while ADS uses straight-line method over a longer recovery period, typically 40 years. Landlords must consider their unique situation and consult with a tax professional before selecting one.

Step 4: Applying the MACRS method

To apply MACRS depreciation for your residential rental property using GDS, follow these steps:

– Divide your rental property’s basis by its recovery period (27.5 years) to find its annual depreciation amount.

– Multiply this annual depreciation amount by a percentage from the IRS MACRS table. The appropriate percentage will vary depending on the month during which your property was put into service.

Example:

Let’s say you purchased a residential rental property for $300,000, of which $200,000 is attributed to the building and $100,000 to the land. You would divide $200,000 by 27.5 years, resulting in an annual depreciation amount of $7,272.73. If your property was put into service in March, using the IRS MACRS Table for GDS with mid-month convention, you would multiply this annual depreciation amount by 2.191% for the first year, giving you a depreciation expense of $15,940.05.

Step 5: Report depreciation on your tax return

Report your rental property’s depreciation on Form 4562 (Depreciation and Amortization) and attach it to your income tax return (Form 1040). Make sure to save records of your basis calculations and other relevant documentation for future reference.

Conclusion:

Calculating depreciation for a rental property can help landlords make informed financial decisions and maximize tax deductions. By understanding how to determine the basis of property, applying MACRS method, and reporting this information correctly on tax returns, landlords can improve their rental business’s overall financial management. As always, consult with a tax professional when dealing with complex financial calculations and strategies.