If you and your mate have invested some of your hard-earned money into a residential rental property, you can take advantage of a tax break from Uncle Sam called depreciation. The Internal Revenue Service allows you to depreciate your rental property by deducting a portion of its cost annually over a 27-1/2 year period, which reduces your taxable income. When figuring your annual depreciation, you must separate the rental property’s cost between the land and the house and may only depreciate the cost of the house. The IRS does not allow the depreciation of land.
Add the amount of settlement fees and closing costs to the price you paid for your rental property to determine your cost basis. Examples of settlement fees and closing costs include legal fees and title insurance. Exclude fire insurance premiums and fees related to obtaining a loan. For example, if you paid $240,000 for a rental property and $10,000 in closing costs, add $240,000 to $10,000 to get a $250,000 cost basis.
Determine the assessed value of your entire rental property, including the house and land, and the portion that is allocated only to the house. You may find this information on your recent property tax assessment notice or bill, or by contacting your local tax assessor’s office. In this example, assume the total assessed value of your rental property is $200,000, of which $160,000 is allocated to the house.
Divide the value of the house by the value of the property. Multiply your result by your cost basis to determine the cost basis of the house, which is the amount you depreciate. Continuing with the example, divide $160,000 by $200,000 to get 0.8. Multiply 0.8 by $250,000 to get a $200,000 cost basis of the house.
Find Table 2-2d on Page 11 of IRS Publication 527. Identify the percentage listed in the “Year 1” column and the row of the month you made your property available for rent. In this example, assume you made your property available for rent in September. The percentage in the September row and “Year 1” column is 1.061 percent.
Multiply the percentage by the cost basis of the house to determine your depreciation in the first year. In this example, multiply 1.061 percent, or 0.01061 by $200,000 to get $2,122 in first-year depreciation on the house.
Multiply 3.636 percent by the cost basis in the house to determine your annual depreciation after the first year. In this example, multiply 0.03636 by $200,000 to get $7,272 in annual depreciation on the house after the first year.
Items you will need
- Property closing documents
- Property tax assessment notice or bill
- Various circumstances, such as making improvements to or moving into a property, can change the amount by which you depreciate your rental property. Consult an accountant to determine the depreciation for your specific situation.
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