A big tax benefit associated with rental property is depreciation. The depreciation tax regulations allow you to write off a portion of the asset's cost as an expense every year until you have written off the entire cost. Most people understand buildings are depreciable. Improvements to the property are also subject to depreciation separately, beginning from the date you replace or remodel the property.
The idea of depreciation grew out of an accounting method developed in the late 19th century. As American industries were developing and growing, they purchased increasingly larger machines, vehicles (such as locomotives) and buildings. Their showing the purchase of one of these large assets in a single year, however, skewed a profit-and-loss statement. Their accountants began splitting the expense evenly over the expected life of the asset, smoothing profit-loss statements and more accurately portraying the relationship between cost, benefit and useful life. In 1913 the Internal Revenue Service adopted this procedure as a tax rule.
While, conceptually, depreciation is easy to grasp, understanding its tax rules is a challenge. Different rules apply to property put into service (that is, rented) at different times. Even current rules in effect for properties put into service after 1986 include two systems and three methods. The general depreciation system (GDS) is the most common, and the alternative depreciation (ADS) system is less common, used principally for nonprofits and certain farm land, although anyone can elect to use this system if he wishes. Within the GDS, you can choose from straight-line or one of two types of accelerated depreciation. If you elect to use ADS, you must select the straight-line method of depreciation. Straight line divides the cost of an asset evenly over its useful life. Accelerated depreciation allows you to claim more depreciation in early years and less in later years.
If you improve a depreciable property, the IRS treats it as separate depreciable property for tax purposes. For instance, if you bought a building five years ago, put on a new roof three years ago and installed a new appliance last year, you would depreciate the building, the roof and the appliance separately. To qualify for depreciation, an improvement must have a useful life of a year or more. If it is less than one year, the improvement is generally reported as maintenance and is fully written off in the year it is made.
Classes of Assets and Useful Lives
The IRS lists a number of common rental property improvements and places them in categories. Appliances, carpets and furniture used in rental property is considered five-year property. Any improvement that is not specifically listed by the IRS is considered seven-year property. Under the GDS, a five-year improvement is written off over five years and a seven-year property is written off over seven years. The building itself is depreciated over 27.5 years. Under the ADS, improvements and buildings are depreciated over longer periods of time.
Mary Gallagher runs Mary Gallagher Planning (mgaplanning.com), an urban planning and consulting business in San Francisco. She is the former assistant planning director for San Francisco and planning director for San Mateo. Gallagher has been writing about real estate, development and land use for numerous websites since 1995. She holds a master's degree in historic preservation planning from Cornell University.