The Internal Revenue Service generally will allow you to depreciate the value of a rental structure over a period of 27.5 years. It's the logical result of the fact that buildings wear out over time, or they become obsolete due to older features that are no longer in demand.
This provides a great way to pare down the rental income that you must pay taxes on.
An Example of Rental Property Depreciation
Using an investment fourplex as an example, begin with a purchase price of $325,000. Assume the property will generate $15,192 a year in positive cash flow if all four units are rented out full time.
Now you can offset some of that income for tax purposes. You can depreciate the building by deducting out the value of the land and dividing the remainder, the building value, by 27.5 years to reach a figure for annual depreciation.
The depreciation calculation would look like this:
- Purchase price less land value equals building value
- Building value divided by 27.5 equals your annual allowable depreciation deduction
Assume that the value of the half-acre of land on which the fourplex sits is $80,000. The calculation would look like this:
- $325,000 less $80,000 equals $245,000 building value
- $245,000 divided by 27.5 years equals $8,909 a year in depreciation
Without taking any other property tax or mortgage interest deductions into account, you've already reduced your taxable rental income by $8,909 annually. And you didn't have to spend any additional money to realize this deduction.
How Depreciation Fits Into the Big Picture
Depreciation is just one deduction you can take for your rental property. There are more savings to be found here.
Claiming a deduction for depreciation requires completing Schedule E with your Form 1040 tax return. You'll enter your annual depreciation here, as well as all the property taxes, interest, and maintenance expenses you paid all year. The total transfers to Schedule 1, which must also accompany your tax return.
The total from Schedule 1 ultimately goes on line 6 of your 1040, representative of your total income for the year. Obviously, you want that number on line 6 to be as small as possible. Deducting depreciation and expenses from your overall rental income is a big step in this direction.
We're talking taxes here, so, of course, there are some qualifiers. The rules for depreciation imposed by the IRS include:
- You must own the property.
- It must generate income—you don't hold it for your personal use.
- Unlike land, it must have a definable "useful life." It will begin to deteriorate and lose value over time.
You can only take a depreciation deduction on Schedule E if you meet these circumstances.
When You're Nearing Retirement
Rental home investing is very popular, especially for new investors or for those who want monthly cash flow now rather than big, short-term profit boosts from wholesaling or fix-and-flip investing. Rental investing can accomplish a lot for you depending on your age and your remaining time until retirement.
You might find that there isn't a very high rate of return coming your way from dividends or interest as you near retirement age and you begin to calculate your monthly income from the stock market and other investments. You could reallocate your assets, selling stocks or bonds and moving that money into rental homes.
There's less risk if you invest wisely, and the returns are typically higher. You'll have more monthly income to fund your looming retirement.
Retirement Planning When You're Young
This is when you can really start building a nice retirement. Begin buying properties as rentals and you'll start gaining equity as the years go by and they appreciate as you pay down the mortgages.
A 1031 exchange will let you avoid capital gains tax if you do it right.
You can take the profits from sales with a 1031 exchange when you sell, and roll them into more rentals, maybe higher-priced homes instead of more of them. A 1031 exchange involves rolling your profits from one property directly into a new property through a designated third party so the money never actually touches your hands.
And if you don't have use of the money yet, it's not capital gains and it's not yet taxable.
The Bottom Line
Rental property investing will always be a great way to invest because there will always be renters. The housing and mortgage crash that began in late 2006 shows how rental property has become a good investment practice. All those people who lost their homes due to foreclosure became renters while they rebuilt their credit and saved for future down payments.
Younger buyers pretty much left the buyers' market for years after seeing their older relatives lose their homes or equity. They also delivered a huge demand for rentals.
Rental home investment is resistant to the negative effects of interest rate increases and inflation. It can be a great way to grow your wealth.