How to calculate depreciation on rental property when selling

The depreciation of the rental property can be termed as the reduction in the rental property value over time due to wear and tear, age and deterioration. It is a systematic allocation of costs and could be used to write off the taxes. And therefore, it helps in lowering taxes.

Table of Contents Show

• Explanation
• How Does it Work?
• Examples of Depreciation for Rental Property
• Depreciation Rules for a rental property
• Requirements
• Disadvantages
• Recommended Articles
• How do you calculate accumulated depreciation on a rental property?
• How do you calculate depreciation on sold assets?
• How is recaptured depreciation calculated?
• How do you calculate gain on sale of rental property?

Mathematically, one can determine it as the division of cost basis of the rental property with a useful life. The following would be the relationship: –

Depreciation = Cost of the Rental Asset / Useful Life of the Asset

Explanation

Investors invest in a rental property and real estate with the intent of financial planningFinancial planning is a structured approach to understanding your current and future financial goals and then taking the necessary measures to accomplish them. Because this does not begin and end in a specific time frame, it is referred to as an ongoing process.read more and having sustainable positive cash flows. The rental property can be utilized for both sustainable cash flows in rent, and enhanced equity valueEquity Value, also known as market capitalization, is the sum-total of the values the shareholders have made available for the business and can be calculated by multiplying the market value per share by the total number of shares outstanding.read more as the property rises in value. It makes liability of taxes as it is an expense that covers the cost of an asset and improves the rental property.

How Does it Work?

• As per the broad rules of the Internal revenue service IRS, the rental properties can be assumed and treated to have a useful life of 27.5 years.
• To arrive at an effective depreciation value, divide the cost of the rental property by the factor of 27.5.
• If a rental property is in the form of commercial property, then the useful life can be assumed to be up to 39 years.
• Land can never be utilized for depreciation; rather, the buildings and properties built on it would be regarded for depreciation.
• The land is considered to have an indefinite useful life.
• A fair tax assessment helps determine the effective value of the land.
• The depreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more is valid until the time the individual owns it. Once it is sold, the individual can claim depreciation on it.
• The individual or the owner can start accounting for depreciation once the rental property is ready for the rental business.

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Examples of Depreciation for Rental Property

Below are some examples explained in detail.

Example #1

Let us take the example of residential property. The cost basis of rental property is $325,000. Per the IRS guidelines, it is assumed that the residential property would have a useful life of 27.5 years. A straight-line depreciation methodStraight Line Depreciation Method is one of the most popular methods of depreciation where the asset uniformly depreciates over its useful life and the cost of the asset is evenly spread over its useful and functional life. read more, helps the owner determine the depreciation on the rental property.

Solution:

• = $325,000 / 27.5
• = $11,818.18

Therefore, the depreciation is $11,818.18.

Example 2

Let us take the example of commercial property. The cost basis of rental property is $340,000. Per the IRS guidelines, it is assumed that the residential property would have a useful life of 39 years. A straight-line depreciation method helps the owner determine the depreciation on the rental property.

Solution:

• = $340,000 / 39
• = $8,717.95

Therefore, the depreciation is $8,717.95.

Depreciation Rules for a rental property

1. As per the IRS, the individual should own the depreciation property.
2. The utilization of the property is for business purposes or income generation activity.
3. There is a determined useful life of the propertyUseful life is the estimated time period for which the asset is expected to be functional and can be put to use for the company’s core operations. It serves as an important input for calculating depreciation for assets which affects the profitability and carrying value of the assets.read more wherein the property is anticipated to have a useful life of more than one year.

Requirements

• The internal revenue service IRS lays broad guidelines over the depreciation for rental property.
• It defines and categorizes which types of properties can be depreciated and would be considered for a tax deduction.
• As per the IRS, the individual should own the depreciation property.
• The utilization of the property is for business purposes or income generation activity.
• There is a determined useful life of the property wherein the property is anticipated to have a useful life of more than one year.
• However, the property doesn’t need to be depreciated if it is put into service and disposed of in the same year.
• One should note that the land cannot be depreciatedThe land is a company asset with an infinite useful life. As a result, it is not subject to depreciation, unlike other long-term assets such as buildings and furniture, which have a limited useful life and thus require their costs to be allocated to the accounting period.read more.
• The depreciation costs cannot include clearing costs, planting costs, and costs of landscaping.
• The effective cost of the property is termed the cost basisCost basis is the valuation of assets at their original or at-cost price inclusive of incidental expenses determined after making relevant adjustments for dividends, stock splits and distribution of return on capital. It facilitates the taxation of assets.read more.
• The cost basis of the rental property is composed of any assumed debts corresponding to the property, legal costs in the acquisition of the property, fee of recording, the survey costs on the property, taxes on ownership transfers, and costs of title insurance.
• One can adjust this cost over the lifetime of the property.
• Legal costs are the costs that the individual has to bear to acquire the rental property.
• The recording fee is the fee payable by the individual to a government agency. It is for property registering or recording the sale of rental property.
• The survey fee is the fee that an individual has to bear towards inspecting the rental property.

Advantages

• The rental property could be utilized for effective tax planningTax planning is the process of minimizing the tax liability by making the best use of all available deductions, allowances, rebates, thresholds, and so on as permitted by income tax laws and rules imposed by a country's government. It contributes to better cash flow and liquidity management for taxpayers, as well as better retirement plans and investment opportunities.read more.
• The rental property could be utilized for comprehensive retirement planning.
• With time, the value of the rental property appreciates.
• If the acquired rental property is in the best  and most desirable location, it helps create a steady stream of cash flowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more for the owner.
• Other rental property-related expenses and depreciation have to be reported in Schedule E of the tax returns to benefit from the deductions on the rental income stream.

Disadvantages

• If the owner has undertaken the rental property at an undesirable location, it is difficult to generate a steady income stream.
• The above situation can reduce the net investmentNet investment is calculated as capital expenditure minus non-cash depreciation and amortization for the period, and it indicates how much the company is investing to maintain the life of its assets and achieve future business growth.read more which, in turn, increases the depreciation expense.
• Other rental property-related expenses can’t be recovered as there is an insufficient generation of an income stream from the rental property.

Conclusion

The depreciation on the rental property offers a tax deduction to be claimed under schedule E of the internal revenue service. Therefore, this helps in the proper tax planning of the individual. Once the owner has sold the rental property, he can no longer claim depreciation on the rental property. The depreciation can be regarded as a non-cash expense that helps write off tax expenses, and it is an easier way to record the asset’s cost on the income statement.

Recommended Articles

This article has been a guide to depreciation for rental property. Here we discuss an example, how depreciation rules work for a rental property, and the advantages and disadvantages. You can learn more about financing from the following articles –

• Unit of Production Depreciation
• Formula of Depreciation
• MACRS Depreciation
• Depreciation Tax Shield