Your cost basis includes the price you paid for the property plus any additional expenses. Unlike market value, the cost basis used for depreciation purposes does not include the value of the lot or land. On top of that, you want to add extra allowable costs such as closing fees or improvements.
Remember, the higher the cost basis is the better, because your non-cash annual depreciation expense will be higher and your taxable income will be lower. Examples of other costs that might be used to increase the cost basis on your tax return include:. Common improvements made to a rental property — items that enhance property value or usefulness, or restore the property to a new or like-new condition — may include:. Note that routine repairs and maintenance are tax deductions that are normally expensed out against operating income instead of added to the cost basis of a property.
The formula for calculating depreciation on a residential rental property is relatively straightforward:. Our annual depreciation expense would be:. Depreciation is a non-cash deduction that assumes a house wears out or depreciates over However, thanks to the benefit of depreciation, our income subject to tax is less than half of that:.
In addition to reducing your amount of taxable income, you can also use depreciation from your rental properties to shift your total taxable income from a higher tax bracket to a lower tax bracket. In the above example we used a full year of depreciation. But what happens if you buy your rental property in the middle of the year. The following table from the IRS compares the month the property was put into service to the percentage of cost basis you can depreciate:.
For the current property owner, there are two ways that depreciation can end:. The cost basis sometimes needs to be adjusted after a property is purchased. Any debt that the buyer assumes from the seller can also be added to the cost basis.
When calculating the cost basis of a rental property it is necessary to deduct the value of the land. The cost basis will typically be adjusted over time.
Other than land value, here are some of the other expenses that can be included in calculating the cost basis when the property is purchased:. For tax purposes, the IRS assumes that residential properties have a determinable useful life of That means that each year the depreciation expense for a residential property is 3.
An old pickup truck rarely is worth more than a new one, but it is common for a rental property in a desirable area to gain value.
One possible way to avoid paying tax on a sale is to replace one investment property with another one without the owner ever pocketing the proceeds. This is called a exchange. The IRS will assume at the time of a sale that you have been taking the deduction and will expect you to pay a depreciation recapture tax, if necessary. If you failed to calculate the depreciation when you should have, you can file amended tax returns for mistakes going back up to three years.
In any event, the rules governing depreciation and deductions for rental properties can get very technical, and they do sometimes change. A property must qualify for depreciation before an investor can claim a rental property depreciation expense. There are several criteria a real estate investor must meet in order to depreciate rental property:.
There are three different ways to depreciate residential rental property. Accurately calculating rental property depreciation can obviously be complicated. A single-family home in Austin, Texas was purchased by a real estate investor and was placed into service as a rental property on January 1, The investor decides to sell and the transaction closes on December 31, , just in time for the new year.
Before the investor can calculate rental property depreciation, the cost basis of the home needs to be determined. Cost basis is the value of the home minus the value of the land the home sits on, plus any closing costs that must be depreciated including:.
Based on this information, the investor can calculate the cost basis of the home:. To calculate the annual rental property depreciation expense, the cost basis of the property is divided by A real estate investor can claim a depreciation expense of 3. To help make calculating depreciation easier, the IRS provides real estate investors with a table to help determine the depreciation percentage to claim based on the month the rental property was placed in service:.
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