Understanding real estate depreciation is a huge advantage for investors, but it’s often misunderstood. Depreciation allows investors to deduct the costs of buying and upgrading a property from their taxes. However, if you plan on selling one of your properties, it’s essential to know what happens to depreciation while selling real estate. Read along as we go over the basics of real estate depreciation and what to do if you’re selling a property.
Contents of this Article:
- How Does Real Estate Depreciation Work?
- What Happens to Depreciation While Selling Real Estate?
- Can You Avoid Claiming Depreciation?
- Tips for Keeping Track of Depreciation
- Stay Ahead With Property Management
How Does Real Estate Depreciation Work?
Understanding the basics of different tax write-offs and technicalities is important for investors and property managers in Northern Virginia. That said, investing in rental properties offers investors several benefits, including depreciation.
Simply put, depreciation allows investment property owners to deduct the cost of upgrading or improving their properties. Depreciation, however, differs from repair and maintenance tax write-offs because it occurs slowly over time, unlike other deductions, which happen instantly.
Depreciating anything requires proving its valuable and functional life. For instance, if a company buys a piece of equipment costing $5,000 and it’s expected to last ten years, it can depreciate at a rate of 10%, allowing you to deduct $500 each year for ten years. This is known as straight-line depreciation.
When it comes to real estate, you can depreciate properties over 27.5 years at an average rate of 3.636%. So, if you own a rental worth $200,000, you can depreciate a total of $7,273 yearly from your taxes. However, since you can depreciate for 27.5 years, once you’ve hit the last year, you can only deduct $3,636.
It’s important to note that only the property, not the land you own, is eligible for depreciation. So, if you purchased a property worth $250,000, but the land value is $20,000, you can only depreciate the building value, which would be $230,000.
Real estate depreciation can save you thousands of dollars throughout your investment. However, if you plan to sell a property for which you’ve claimed depreciation, you’ll need to recapture the costs as taxable income.
What Happens to Depreciation While Selling Real Estate?
Depreciation is a valuable deduction for rental property owners since it helps offset natural wear and tear or damages that happen over time. However, if you plan on selling the property, depreciation that’s been taken out must be recaptured and paid back to the government. In addition, since depreciation is considered a form of deferred income, when the property sells, it becomes taxable.
To calculate the depreciation you must pay back, you have to know your cost basis. This includes the original purchase price and any upgrades you’ve made. So, if you purchased the rental (excluding land) at $200,000, paid $10,000 in closing costs, and made about $50,000 worth of improvements, here’s how you’ll find the initial cost basis.
$200,000 + $10,000 + $50,000 = $260,000
However, along with lowering your taxable income, depreciation adjusts the cost basis of your property. So, if you’ve owned a $260,000 property for ten years and claimed depreciation each year for a total of $94,536, your adjusted cost basis would drop to $165,464.
Suppose you sell the property for $300,000–more than you paid for it–then you’d subtract the depreciated value to determine your gain. Here’s what it would look like for this example:
$300,000 – $94,536 = $205,464
Since the gain is so large, the IRS recaptures some of that money and taxes 25% of the depreciated value. ($94,536 x 0.25) So, you’d end up paying back $23,634 plus whatever you owe in capital gains tax.
Can You Avoid Claiming Depreciation?
Ultimately, you can’t avoid depreciation recapture, even if you don’t claim depreciation. IRS Code Section 1250 states that depreciation must be recaptured if it is allowable for the property. So, even if you don’t claim depreciation for the years you owned the property, you’ll still have to pay tax on the gain when you decide to sell.
While it’s hard to avoid depreciation recapture, there are a few ways to avoid paying capital gains tax. For instance, a like-kind exchange, or 1031 tax-deferred exchange, can help defer paying capital gains tax on an investment property by reinvesting it in another property.
Another way to avoid paying capital gains tax is by making the property your primary residence. However, you’ll still have to pay depreciation recapture if you decide to sell it.
Tips for Keeping Track of Depreciation
It’s crucial to keep track of depreciation when you own rental properties. After all, investors can use depreciation to offset rental income from a property and reduce tax liability. That said, it can be much harder to track depreciation and capital gains than explained in this article.
For instance, when reporting depreciation to the IRS, you must separate expenses, income, and losses. Additionally, while depreciation is a valuable tool for investors, it’s crucial to track how much you’re writing off. Finally, while the IRS is generous with allowing deductions for depreciation, it’s important to understand that you’ll need to pay some of this money back.
As most investors aren’t tax experts, it’s essential to work with a tax professional to help decipher your expenses and finances. Some helpful tax professionals to work with include Certified Public Accountants (CPA), tax attorneys, or Enrolled Agents (EA).
Stay Ahead With Property Management
A downside to real estate depreciation is that you must pay it back if you decide to sell your property. However, one of the best ways to stay organized and on top of your finances is with property management. Whether you’re investing in a new property or downsizing the number of rentals you have, property management can help you keep track of it all.
Professional Property Management in Northern Virginia provides a wide range of services to ensure your rental business succeeds. Whether you need help communicating with tenants, maintaining rentals, or keeping track of finances, we’ve got you covered. So, contact PPM to learn more about our property management services and how we can help you today!