Condo Depreciation: How It Works and What to Know for Rentals

Understanding condo depreciation is crucial for rental property owners aiming to maximize tax benefits. Depreciation allows owners to recover the cost of income-producing properties through annual deductions, significantly impacting profitability.

This article explores key aspects of condo depreciation, offering insights into how it works and what rental property owners need to know.

Depreciation Eligibility

To qualify for depreciation, a condo must generate income, such as through rental activities. According to the IRS, the property must be owned by the taxpayer and used in a trade or business or held for the production of income. It must also have a useful life exceeding one year, which excludes personal residences and non-business properties.

Residential rental properties, including condos, are depreciated under the Modified Accelerated Cost Recovery System (MACRS), which specifies a recovery period of 27.5 years for residential rentals. This classification determines the method and duration of depreciation, influencing annual deductions.

Improvements to the condo, like a new roof or HVAC system, are depreciated separately. These must be capitalized and depreciated over their specific useful lives, offering additional deductions beyond the base property.

Calculating Depreciation Basis

The depreciation basis of a condo is typically the purchase price, excluding land, which is not depreciable. Allocating the total purchase price between the land and the building often relies on property tax assessments or independent appraisals.

Adjustments may include costs that add to the condo’s value, such as closing costs like legal fees, title insurance, and recording fees. These are part of the initial investment and should be included in the basis calculation.

Significant renovations or improvements that extend the property’s useful life or enhance its value must also be capitalized and added to the depreciation basis. Keeping detailed records of these changes is critical for substantiating the increased basis during an IRS audit.

Duration Under Current Tax Guidelines

Under current tax guidelines, residential rental properties like condos have a recovery period of 27.5 years under MACRS. The straight-line method ensures uniform annual deductions throughout the recovery period, aiding financial planning and tax forecasting.

Consistent depreciation deductions during the initial years of ownership can offset rental income, reducing taxable income and improving cash flow. This predictable schedule helps owners plan reinvestments or anticipate tax liabilities, influencing the property’s net operating income and return on investment.

Rental vs Mixed Use Allocations

For properties used for both personal and rental purposes, expenses and depreciation must be allocated based on usage. If a condo is rented for 200 days and used personally for 165 days, only the rental portion of expenses and depreciation can be deducted. Accurate record-keeping is essential.

The IRS applies “vacation home” rules under IRC Section 280A to determine allowable deductions for mixed-use properties. If personal use exceeds the greater of 14 days or 10% of rented days, the property is considered a personal residence, limiting deductible expenses and rental loss claims. Owners must carefully categorize expenses based on the ratio of rental to personal use.

Depreciation Recapture at Sale

When a depreciated condo is sold, tax implications include depreciation recapture. This requires taxpayers to treat previously claimed depreciation as taxable income. The IRS imposes a recapture tax rate of up to 25% on the portion of the gain attributable to depreciation, as outlined under IRC Section 1250.

For example, if a condo purchased for $300,000 has a $250,000 depreciable basis and $50,000 of depreciation was claimed, the $50,000 is subject to the recapture tax upon sale. If the property sells for $400,000, the $50,000 gain from depreciation is taxed at the recapture rate, while the remaining $100,000 gain is taxed at the capital gains rate.

To reduce this tax burden, property owners may consider a Section 1031 like-kind exchange, deferring both capital gains and depreciation recapture taxes by reinvesting proceeds into a similar property. Following IRS 1031 exchange rules, including timelines and property identification requirements, is essential. Proper documentation and consulting a tax professional can help ensure accurate reporting and minimize unexpected tax liabilities.