What Is Depreciation?


UPDATED: SEP 2020 | 2 MIN READ

Depreciation is a cost deduction process used when buying or improving properties. For rental property owners, understanding depreciation can effectively decrease tax liability and allow you to measure the value of your property over its useful lifespan. Depreciation is often associated with the reduction of value, but it can offer great benefits to rental property owners.

How Does Depreciation Work?

An important detail to note is that property depreciation can only be claimed if the property is being used for a business purpose. Businesses can claim depreciation for properties and asset costs for tax deductions, therefore reducing their taxable income. This process is overseen by the Internal Revenue Service (IRS), who essentially give rental property owners an allowance for the gradual wear and tear of their property. The IRS states that a rental property can be depreciated as soon as it is in service for rent. However, some businesses may choose to depreciate their property or assets once they reach a specific threshold amount. Property owners can continue to depreciate their property when they’ve deducted their entire cost or have retired their property from service.

Calculating The Depreciation of Your Property

There are three main factors you must consider in order to calculate the amount of depreciation you can deduct each year: the property’s basis, the recovery period, and the depreciation method.

  • Property Basis – The basis of a property refers to the total cash amount paid to acquire that property. This includes settlement fees, closing costs, legal fees, back taxes, or insurance charges. There may be some costs that are not included in the basis, so contact a tax professional to get an accurate measure of your property basis.
  • Recovery Period – The recovery period is the duration of time in which a business or property owner depreciates an asset. The length of this period varies from asset to asset depending on its useful life. 
  • Depreciation Method – Two distinct recovery systems are used to calculate depreciation. The first is the General Depreciation System, and the other is the Alternative Depreciation System. Both are described in detail below.

Types of Depreciation Systems

Residential rental properties placed in service after 1986 are depreciated using the Modified Accelerated Cost Recovery System (MARCS) set by the IRS. This system spreads costs and depreciation deductions over 27.5 years – the amount of time the IRS considers the useful lifespan of a rental property. Within the MARCS, there are two subsystems used to calculate depreciation.

General Depreciation System

The General Depreciation System (GDS) is the most common system and uses a declining balance method to depreciate assets. This means that the depreciation rate of 3.636% is set against the non-depreciated balance. It abides by the 27.5 year lifespan set by the IRS, meaning its recovery period is shorter.

Alternative Depreciation System

The Alternative Depreciation System (ADS) uses a straight-line method, meaning it reports equal depreciation expenses each year over the course of an asset’s useful life. The IRS has specific rules for which businesses can use the ADS and is typically reserved for some tax-exempt properties, properties whose use for business purposes is less than 50% of total square footage, and farming equipment (under certain circumstances). The recovery period for ADS is 40 years if the property was placed in service before January 2018. If placed after that date, the recovery period is 30 years.

When is a Property Deemed as Depreciable?

Based on the rules established by the IRS, a property is depreciable when it meets the following requirements:

  • You or your business are listed as owner on the property deed
  • The property is used for business and produces income
  • The property has a determinable useful life
  • The property is expected to last or is used for businesses purposes for over a year

Even if all requirements are met, a property will not be deemed depreciable if it’s not being used for a business purpose.

What Affects a Property’s Value?

Before buying or selling a property, keep in mind that there are several factors that can affect its value over time. These various factors can greatly influence the conditions of the housing market and should be considered before buying or selling.

Location

The location of your property has a significant impact on its value. Determining value is often contingent on three main factors: employment opportunities, proximity to popular businesses, and quality of local schools. Additionally, a property within close proximity of main highways and public transportation can increase its overall value. 

Comparable Properties

A good indicator of a property value is the recent sale prices of similar properties in the same area. These properties are often referred to as real estate comps. Properties with similar features and location details will usually be of similar value.

Size and Usable Space

The size of a property has a big influence on its value, as sales prices will typically be referred to in terms of square footage. A bigger house will sell at a higher price, but keep in mind that garages, basements, and attics may not be considered ‘usable space.’ This means that a house can be listed as 1,800 sq. ft. but have a 600 sq. ft. garage, leaving you with 1,200 sq. ft. of living space. 

Age and Condition

Newer properties are typically appraised at a higher value because they require less maintenance and little to no renovations. However, an older home that’s been well-maintained over the years can also be of high value if it’s in good condition. Condition is determined by the integrity of the property’s foundation, structure, electricity, plumbing, and more.

Market Supply & Demand

The supply and demand for other properties in the same area can influence price. If there is high demand for homes but a fixed supply, the area is considered a seller’s market, and prices will increase in response to competitive buyers. Conversely, if there is little demand and an abundance of properties, it’s considered a buyer’s market and prices will decrease or become negotiable.

Property Upgrades

Upgrading outdated features or making large additions to your property adds to its overall value. The impact of a home improvement project is different across national markets, but will always increase home value even by a small percentage.

Economic Conditions

The broader economic conditions of a neighborhood or city affects how many people are willing to buy or sell property. Housing markets struggle when employment and wage rates decrease, as fewer people are interested in buying. When the economy booms and employment rates increase, people are more open to buying and property prices increase. 

Interest Rates

Understanding the current interest rate trends of the local market can help you determine which properties you can afford. If a bank decides to increase the interest rate on a home loan, monthly mortgage payments will become more expensive. Conversely, decreased interest rates can make a property more affordable for buyers.

How Do You Increase The Value of Your Property?

It’s possible to implement renovation or upgrade projects to increase a property’s market value and appeal. Below are some ideas for how you can increase your property value.

  • Room Renovations – Remodeling parts of your property can increase its appeal to buyers on the market. Some of the most cost effective renovation projects are: siding replacement, kitchen or bathroom remodel, deck addition, and door replacement.
  • Add Space – Bigger homes are often listed at a higher value. You can add living space to your home by either knocking down or adding walls to create more open space or more rooms. There could be a closet you could turn into a half-bathroom, or a basement you can turn into a den.
  • Increased Energy Efficiency – Promoting energy efficiency in homes can attract buyers. To build value and conserve energy costs, consider implementing the following eco-friendly features: energy efficient lighting/appliances, solar panels, energy conserving landscaping, and proper compost/recycling areas.
  • Improve Technology – Updating the various systems and appliances within your property adds to its overall value. Some possible home technologies you can update are: security systems, locks, carbon monoxide and fire detectors, and thermostats.

Things To Consider When Purchasing/Selling Property

When buying or purchasing a property, it’s best to understand the current status of the market and the value of the property you wish to buy or sell. While there’s no simple way of calculating property value or depreciation rate, you can stay informed by contacting a tax professional and understanding the features of your property.

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