One of the benefits of owning rental properties is the ability to take a depreciation expense deduction on your income tax return. But what is depreciation? And how is it calculated? And what will my benefit be?
Depreciation is used to recover the cost of your rental property through yearly tax deductions. You will do this by deducting some of the cost of the property on your tax return each year.
Three factors determine how much depreciation you can deduct each year.
1. Your basis in the property
2. The recovery period for the property
3. The depreciation method used
One of the first things to note is that land is not depreciated so you will need to determine how much of the cost of your rental property is building and how much is land. Since land is not “used up” it is never depreciated. You can usually figure out how much the land value is by looking at the tax assessor’s records.
So let’s explore an example of how to calculate depreciation on a rental property.
You purchased a rental property on January 1, 2014 for a cost of $120,000. The tax assessor records show that the value of the land is $20,000. So you have $100,000 that you can depreciate. By tax law, rental property is depreciated over a period of 27.5 years. In 2014, you will effectively get a depreciation expense deduction of approximately $3,600 for the year.
Assume your rental property has positive cash flow of $400 per month or $4,800 per year. The profit after depreciation in this example is $1,200. Because of the depreciation deduction, you can have $4,800 in cash flow and pay tax on only $1,200.
Depending on your personal tax bracket, you might recognize tax savings of $700 to $1,400. And this is just the depreciation deduction.
There are a lot of factors that go into calculating the basis in your property and your personal tax bracket will determine how much tax savings you can realize.
Find a reputable tax professional who can help you with your depreciation calculation and the calculation of your property basis.
Contact ABIP CPA today if you need further information!