Investing in real estate is one of the best ways to build wealth and cut taxes.
Benefits include the ability to 1) recover the cost of income-producing property through depreciation, to 2) use 1031 exchanges to defer profits from real estate investments, and 3) borrow against real estate equity to make additional investments or for other purposes. Additionally, homeowners can 4) benefit from the personal-residence exemption, which shields profits on the sale of a personal residence from capital gains taxes, as well as 5) the deduction for mortgage interest.
What is Depreciation?
Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life and is used to account for declines in value.
The Internal Revenue Code defines the depreciation deduction as a reasonable allowance for exhaustion or wear and tear, including a reasonable allowance for obsolescence.
Homeowners can claim a depreciation write-off if you use a portion of their home as a rental property or if you have a designated home office.
In the context of a rental property, depreciation is a tax deduction for the expenses used to purchase and enhance the property. The IRS allows you a depreciation expense for your rental property depending on certain circumstances.
You have to 1) own the property, and 2) be using it as a source of income. The property must also 3) have a useful lifespan that you can not only determine, but determine will be longer than one year.
If you meet all three of these qualifications, you can start deducting depreciation expenses once you begin using it for renting and it generates income for you. The depreciation stops if you stop getting income from the property; if you continue to rent it, it ends once the entire cost has been deducted.
Real estate investors generally use a depreciation method called the Modified Accelerated Cost Recovery System (MACRS), in which residential rental property and structural improvements are depreciated over 27.5 years, while appliances and other fixtures are depreciated over 15 years.
Depreciation expense often results in a net loss on investment property even if the property actually produces a positive cash flow. This loss, as well as expenses, such as utilities and insurance, are reported on Schedule E, federal income tax form 1040, and deducted from ordinary income.
When you own an investment home, the IRS allows you to depreciate the entire value of the building. Calculating depreciation on a property used exclusively as a rental is simple — divide the value of the building by 27.5. For example, a $400,000house yields $14,545.45 in annual depreciation.
Most people know that when they sell a home (own as an investment) they must pay capital gains taxes on any profit that they earn over the original purchase price. They also must pay a 25 percent federal recapture tax on any depreciation that they claimed if the property sells for above the depreciated value.
In a 1031 Exchange, you carry your depreciated basis forward to your new property, saving you capital gains taxes or recapture tax at the time of sale.