Can Rental Property Depreciation Offset Ordinary Income?

Understanding Rental Property Depreciation

Owning a rental property involves various financial considerations, including the potential for reducing taxable income through legitimate expenses. One significant non-cash deduction available to rental property owners is depreciation. This allows owners to account for the gradual wear and tear and obsolescence of the property over time, which can lower their overall tax liability.

Depreciation is a method of recovering the cost of certain property over its useful life. The Internal Revenue Service (IRS) permits property owners to deduct a portion of the cost of income-producing property each year. This deduction reflects the decline in value of an asset as it ages and gets used, even though no actual cash outlay occurs in the year the deduction is taken.

Eligible property for depreciation includes buildings, structural components, and other assets used in the rental activity, such as appliances, furniture, and improvements like new roofs or heating systems. These items must be owned by the taxpayer, used in the rental activity, and have a determinable useful life that extends beyond one year. Land is never depreciable because it is considered to have an indefinite useful life.

The primary purpose of depreciation is to spread the cost of an asset over the period it is used to generate income, aligning expenses with revenues for tax purposes. Because it is a non-cash expense, it can create a tax deduction without requiring an equivalent cash outflow in the same tax year. This aspect makes depreciation a valuable tool for reducing the taxable income derived from rental activities.

Passive Activity Loss Rules

Rental activities are generally classified as passive activities by the Internal Revenue Service. This classification means that any losses generated from these activities, including those from depreciation, can typically only be used to offset income from other passive sources. Wages, salaries, and business profits are considered non-passive income, and passive losses cannot ordinarily be used to reduce these types of income.

However, there are specific exceptions to the general passive activity loss (PAL) rules that allow rental property owners to potentially deduct losses against ordinary income. One such exception is the special allowance for individuals who actively participate in rental real estate activities. Under this rule, taxpayers may be able to deduct up to $25,000 of passive losses against non-passive income. This allowance is available if the individual actively participates in the rental activity and owns at least 10% of the property.

Active participation typically involves making management decisions, such as approving new tenants, deciding on rental terms, or authorizing repairs. It does not require regular, continuous, or substantial involvement like material participation. The $25,000 special allowance begins to phase out for taxpayers with modified adjusted gross income (MAGI) exceeding $100,000 and is completely eliminated when MAGI reaches $150,000.

A more significant exception to the passive activity rules applies to individuals who qualify as real estate professionals. If a taxpayer meets the criteria to be considered a real estate professional, their rental real estate activities are not automatically treated as passive activities. This allows them to deduct all rental losses, including those stemming from depreciation, against any type of income, including wages or business profits, without the $25,000 limitation or income phase-out.

To qualify as a real estate professional, a taxpayer must satisfy two main tests. First, more than half of the personal services performed in trades or businesses during the tax year must be performed in real property trades or businesses in which the taxpayer materially participates. Second, the taxpayer must perform more than 750 hours of service during the tax year in real property trades or businesses in which they materially participate. Material participation generally requires regular, continuous, and substantial involvement in the operations of the activity.

Determining Depreciable Basis

Before calculating the annual depreciation deduction, property owners must determine the depreciable basis of their rental property. The depreciable basis represents the portion of the property’s cost that can be recovered through depreciation deductions over its useful life. This initial basis is typically the cost of the property, which includes the purchase price along with certain acquisition costs incurred to put the property into service.

Acquisition costs that are added to the purchase price to establish the initial basis can include various expenses. Examples of such costs are legal fees, title insurance premiums, surveys, recording fees, and transfer taxes. These costs are considered part of the overall investment in the property and are therefore included in the amount that can be depreciated over time.

The cost of any substantial improvements made to the property after its acquisition also increases the depreciable basis. An improvement is a betterment that adds value, prolongs the useful life, or adapts the property to new uses, rather than simply repairing it. For instance, adding a new room, replacing an entire roof, or upgrading the electrical system would typically be considered improvements that increase the depreciable basis.

A crucial aspect of determining the depreciable basis for rental property is the exclusion of land value. Land is not considered to wear out or become obsolete, so it is not depreciable for tax purposes. Therefore, the total cost of the property must be allocated between the land and the building, with only the building’s value and any depreciable improvements forming the depreciable basis. Common methods for allocating the purchase price include using the assessed values from property tax statements or obtaining a professional appraisal to determine the relative values of the land and the structure.

Calculating Annual Depreciation

Once the depreciable basis of the rental property has been established, the next step involves calculating the annual depreciation deduction. For most residential rental properties, the Modified Accelerated Cost Recovery System (MACRS) is the required depreciation method. MACRS provides specific recovery periods over which the cost of the property can be depreciated.

Residential rental property is generally depreciated over a recovery period of 27.5 years. Non-residential real property, such as commercial buildings, typically has a longer recovery period of 39 years. These recovery periods are set by tax law and determine how quickly the cost of the property can be expensed for tax purposes.

Under MACRS, a specific convention applies to real property known as the mid-month convention. This convention assumes that any real property placed in service or disposed of during a month is considered to have been placed in service or disposed of in the middle of that month. This means that depreciation is calculated for half of the month in which the property is placed in service, regardless of the actual day it becomes ready for use.

The “placed-in-service” date is when the property is ready and available for rent, even if tenants have not yet moved in. Depreciation begins on this date. Taxpayers can find detailed guidance and depreciation tables in IRS Publication 527, “Residential Rental Property (Including Vacation Homes).” For a simplified illustration, if a residential rental property has a depreciable basis of $275,000, the annual depreciation deduction would be approximately $10,000 ($275,000 / 27.5 years), subject to the mid-month convention. This annual amount is then claimed as a deduction on the property owner’s tax return.