When you purchase an asset to generate income, like a rental house, you can deduct its annual depreciation from your taxes. Depending on your property's revenues and expenses for the year, you may be unable to apply the depreciation deduction against your income. You should still claim the deduction, so it is carried forward to future returns, as there is no advantage to not claiming depreciation.
To encourage business investments, the Internal Revenue Service allows a deduction for the cost of assets used to generate income. You cannot deduct the full cost of an asset in its first year of use. This deduction must be spread over the expected life of the asset to match its annual wear and tear, known as depreciation. The IRS lists the expected life of different asset classes under the depreciation section of its website. You must use this schedule for your annual deduction.
Rental House Depreciation
The IRS considers a rental property to have an expected life of 27.5 years. To calculate your annual depreciation percentage, divide one by the life of your asset. For a rental home, you may deduct 3.64 percent of its purchase price each year. By taking a depreciation deduction, you reduce the cost basis of your home. When you sell your home, your basis is returned tax-free and all sale proceeds above the basis are taxable.
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When you earn income from a rental property, the IRS classifies the income as passive income. Passive income is generated from owning an asset, not from your own personal efforts. You cannot apply the expense deductions from a passive activity against your regular income. If your total rental expenses exceed your rental income, the annual depreciation of your home does nothing to reduce your taxes. This creates a scenario where it seems to make sense to skip depreciation, so that you have a higher tax basis for the future sale of your property.
It does not make sense to skip a depreciation deduction because the IRS imputes depreciation, meaning that even if you don't claim the depreciation against your property, the IRS still considers the home's basis reduced by the unclaimed annual depreciation. You have the same adjusted cost basis for selling your rental property whether you claim the depreciation deduction or skip it. Because of imputed depreciation, you may as well claim depreciation, even if you can't use it this year. You can carry the deduction forward to your future tax returns.
Read More: How to Sell Rental Property
- Internal Revenue Service: Publication 946 (2019), How To Depreciate Property
- Internal Revenue Service: Publication 527 (2010), Residential Rental Propert
- Internal Revenue Service (IRS). "Publication 527 (2018) Residential Rental Property: Depreciation of Rental Property." Accessed Jan. 10, 2020.
- Internal Revenue Service (IRS). "Frequently Asked Questions: Property (Basis, Sale of Home, etc.)." Accessed Jan. 10, 2020.
- Internal Revenue Service (IRS). "Frequently Asked Questions: Sales, Trade, Exchanges." Accessed Jan. 10, 2020.
- Cornell Law School Legal Information Institute. "26 U.S. Code § 1250.Gain From Dispositions of Certain Depreciable Realty." Accessed Jan. 10, 2020.
David Rodeck has been writing professionally since 2011. He specializes in insurance, investment management and retirement planning for various websites. He graduated with a Bachelor of Science in economics from McGill University.