After each tax season, taxpayers will receive their refunds—or end up in dutch to Uncle Sam. And, although Americans can take advantage of numerous tax deductions, the number of options can be hard to parse, or process. Fortunately, property owners can take advantage of a benefit which grants a reduction in taxes they owe. This benefit (called a "depreciation deduction") is an easy and legal way to minimize tax liability, and property owners should be prepared to take full advantage.

What is the Depreciation Deduction?

Depreciations are income tax deductions that permit property owners to recover the cost of assets over time. The IRS makes an annual allowance for a property's deterioration, for wear and tear, and for obsolescence—one that applies to tangible property (buildings, machinery, equipment, and vehicles) as well as intangible property (computer software, patents, and copyrights). 

As with all tax rules, there are requirements and limitations. The property must be owned by the taxpayer; the deduction can’t be used on a rented or borrowed assets. Properties that have depreciated must be have been used for business purposes, or for income-producing activities. Lastly, the property must have existed for more than one year. (See: An Introduction to Depreciation)

The Factors Involved

Depreciations are determined by the following factors:

  • The original cost of the property.
  • The time it takes to recoup.
  • The type of depreciation.

The type of depreciation is governed by the Modified Accelerated Cost Recovery System, which applies if a property was placed in service, or used as an investment, after 1986, and allows for greater deduction amounts towards the start of the property’s life. An Accelerated Cost Recovery System is used for properties placed in service between 1981 and 1986, and Straight Line Depreciation—which spreads cost equally over a property's lifetime—applies to assets purchased prior to 1981. While yearly deductible amounts may vary, underlying principles remain the same.

Take, for instance, Straight Line Depreciation. Suppose a taxpayer's purchased a residential property with a basis of $100,000 and a recovery period of twenty years. This arrangement allows the owner of the property to deduct $5,000 per year for twenty years. Depending on the owner's overall tax situation, this $5,000 deduction could lead to thousands of dollars of savings, per tax year, over the twenty-year span.

Rental properties only depreciate when they're placed in service for investment or business reasons. If a residential property was bought two years ago, but the owner did not rent the property for those first two years, depreciation doesn't apply, but starts as soon as the property is rented out to a paying tenant. On the other hand, additions and improvements to property can be added to the cost basis (this includes direct costs like materials and labor). This benefits here are two-fold, because the property's values appreciate due to improvements while the cost basis is also increased. creating more opportunities for tax deductions.

IRS Publication 527 explains rental property depreciation rules in much greater depth, while IRS Publication 946 provides a general overview of depreciation deductions for business and income-producing properties. These two publications will also tell owners which documents they'll need to use to track and report depreciable assets.   

The Bottom Line

The Depreciation Deduction is an effective, legal method for retrieving the costs paid for real estate assets for periods of up to forty years. 

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