The benefits of depreciation are so great that they should convince many to at least consider investing in rental properties.
Depreciation occurs naturally over time to physical assets, in this case real estate.
Rental property depreciation is actually one of the greatest benefits awarded to qualifying passive income property owners.
Depreciation has become synonymous with the reduction of an asset’s value. As a result, most homeowners have come to resent the idea of depreciation. Who doesn’t hate the idea of their assets losing value?
It is worth noting, however, that depreciation isn’t your enemy; it’s just misunderstood. In fact, rental property depreciation is actually one of the greatest benefits awarded to qualifying passive income property owners. You see, the Internal Revenue Service (IRS) allows qualifying property owners to write off a portion of the asset’s initial cost each year in the form of “depreciation losses.” Qualifying owners are, therefore, allowed to recoup a portion of the initial cost of the home every year for as many as 27.5 years. Perhaps even more importantly, said deductions can reduce an investor’s tax obligations come tax time. The more they write off, the less they will have to pay in taxes, which begs the question: How much does a house depreciate per year? Better yet, how much money can the depreciation deduction save you?
The answer may come as a surprise, and perhaps even persuade you to look at acquiring your own passive income properties.
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Homes absolutely depreciate in value. As a physical asset, time takes its toll on any and every home on the market. Perhaps even more importantly, that’s how the IRS sees it, too. In fact, the powers that be (the IRS) have been kind enough to offset said depreciation with an allowance of sorts.
Otherwise known as depreciation losses, the IRS willing to give rental property owners “allowances for exhaustion, wear and tear (including obsolescence) of property.” According to their own website, “You begin to depreciate your rental property when you place it in service. You can recover some or all of your original acquisition cost and the cost of improvements by using Form 4562, Depreciation and Amortization, (to report depreciation) beginning in the year your rental property is first placed in service, and beginning in any year you make improvements or add furnishings.”
So again, do homes depreciate in value? In the eyes of the IRS they most certainly do. However, as I am sure you are already aware, homes don’t always depreciate in value on the actual housing market. More often than not, homes have a tendency to appreciate — at least that’s what history suggests. Therein lies the greatest depreciation benefit of them all: phantom losses.
Again, the IRS has already said it accepts that homes will depreciate over a 27.5 year period. As a result, qualifying rental property owners can write off a portion of the original cost each year, effectively reducing their tax obligations. However, home values typically rise over time. So while many rental property owners are allowed to claim depreciation, the actual value of their home may in fact increase over time.
1. How Much Does A Home Depreciate Per Year?
Homes depreciate 3.636% per year, on average, according to Investopedia. That number is reserved for homes placed in service for an entire year, however. Homes that were only placed in service for a portion of the year will only be allowed to depreciation a portion of the average, in relation to the time it was in service.
2. Home Depreciation Calculation
In order to correctly depreciate a property, you must first identify three fundamental indicators: the property’s basis, the duration of recovery, and the method in which you are going to depreciate the asset.
First things first, the basis of the property represents the total acquisition costs incurred from buying the home. The basis may include settlement fees, closing costs and other expenditures that came out of your own pocket at the time of the purchase (think legal fees, back taxes and insurance). That said, not all costs count towards the basis, so be sure to consult a tax professional for a better idea of what my be included. The land the home is sitting on, for example, may not be included in the basis. Only the value of the home may be depreciated (not the land).
Next, you’ll need to determine which method you intend to use to depreciate the asset. There are two distinct recovery systems to use: the General Depreciation System (GDS) or the Alternative Depreciation System (ADS). GDS is the most common, but, again, be sure to consult a tax professional before moving forward with this step.
The General Depreciation System will allow owners to depreciate a portion of their initial cost every year over a period of 27.5 years. The Alternative Depreciation System will allow owners to depreciate a portion of their initial cost every year over a period of 40 years.
Once you have all the necessary variables, you will need to divide the basis by the duration of depreciation allotted by the IRS. Once again, rental property depreciation may be complicated, so do not attempt to depreciate a home on your own. Always consult a tax professional.
3. Factors That Affect Property Value
There are seven factors that affect property value more than anything else. And while the following factors are in no way representative of everything that influences a home’s value, they are perhaps the most important — the tent poles, if you will:
Age And Condition
First and foremost, those looking to properly value a home will resort to its own sales history, and the sales history of nearby comparables. That way, the valuation will be based on historical data, and not something that is—at best—questionable. Next, a proper evaluation will take the home’s location into consideration. Everything from the zip code, city street and neighborhood all go into a proper evaluation. It is true what they say: real estate is all about location, location, location. Another prominent factor in valuing a property is the current state of the market. If for nothing else, supply and demand plays a huge role in determining value. Low inventory levels coupled with high demand will certainly drive up prices. What’s more, prices can just as easily drop in the face of inventory surpluses without demand. And finally, there’s the house itself. The size, style, age and condition are all factored into a proper evaluation.
There are countless factors that go into properly determining a home’s value — too many to count even. That said, the seven I hit on above are the most important, and are perhaps even the reason most homes tend to appreciate more often than not. At the very least, it’s these factors that combine to make deprecation losses even more rewarding for homeowners.
4. House Depreciation Rate
The house depreciation rate will depend largely on the system you intend to use, as there are two primary ways to calculate your own deprecation. If you depreciate your asset using the General Depreciation System, which lasts 27.5 years, “you would depreciate an equal amount: 3.636% each year as long as you continue to depreciate the property,” according to Investopedia. However, using the Alternative Depreciation System (ADS) will span upwards of 40 years, and result in a subsequent house depreciation rate.
That said, calculating your own home’s depreciation rate is no simple task. It is a complicated process at best, and should be left to a trained tax professional.
5. What Is Accelerated Depreciation?
As its name suggests, accelerated depreciation suggests an asset is losing value at a faster rate. Or, as InvestingAnswers so eloquently puts it, “Accelerated depreciation is a depreciation method whereby an asset loses book value at a faster rate than the traditional straight-line method. Generally, this method allows greater deductions in the earlier years of an asset and is used to minimize taxable income.”
It’s important to note that accelerated depreciation takes place in the earlier years of an asset. As for rental properties, the earlier years are the first 27.5, at least according to the Modified Accelerated Cost Recovery System (MACRS). Created in lieu of the Tax Reform Act of 1986, the MACRS grants rental property owners the ability to depreciate their assets over a period of 27.5 years — the “early” stages of a property. That said, the entire process of depreciation is a product of accelerated depreciation.
6. How To Increase The Market Value Of A Property
Learning how to increase the market value of a property, in addition to rental property depreciation, can really help a homeowner’s bottom line. That said, if you want to increase the perceived value of your own home, try implementing some of these projects that have some of today’s best return on investment (ROI):
Mid-range Bathroom Remodel: The average mid-range bathroom remodel will cost homeowners approximately $19,143, but will recoup about 70.1% of the cost if the home is sold.
Steel Entry Door Replacement: The average steel entry door replacement will set owners back about $1,471, but recoup about 91.3% at the time of a later sale.
Mid-range Kitchen Remodel: A mid-range kitchen remodel costs about $63,829, but could recoup as much as 59.0%.
Siding Replacement: On average, it costs about $15,072 to replace siding on a home, but the project could recoup 76.7% at the time of a sale.
7. Home Depreciation Calculator By Type
All physical assets, real estate included, depreciate over time, particularly in the eyes of the IRS. However, the depreciation deductions available will actually vary based on what the home is used for. For property owners, this means your potential tax savings will depend on the investment type. This information is important to consider as you evaluate the potential returns of different real estate deals. Here is an overview on the depreciation of houses by property type:
Rental Property: One of the greatest benefits to owning a rental property is the depreciation deduction. Investors can follow the steps above when calculating the depreciation of any passive income properties.
Main Residence: Personal properties are not eligible for the depreciation deduction. This is because depreciation specifically applies to income-generating assets or investments. To keep things simple: homeowners do not earn income from their property and therefore cannot use the depreciation deduction.
Owner-Occupied Duplex: Duplexes navigate a fine line when it comes to depreciation. Essentially, property owners will treat the units as two separate properties. For tax purposes the tenant-occupied portion would be depreciated while the owner-occupied portion would not.
Home Office: According to the IRS, home offices are treated similarly to commercial properties. Property will need to determine the percentage of the home that the office occupies in order to determine the deductions available. Additionally, commercial real estate can be deducted over a 39 year period.
[ Do you want to know the deprecation rates for commercial real estate? Read this article to learn more ]
How much does a house depreciate per year? I regret to inform you that there isn’t a simple answer. However, there are systems currently put inlace to make sure you are depreciating your own asset accordingly. To be certain, I recommend hiring a trained tax professional. You just might find it to be the one advantage you have been looking for.
Have you ever wondered how rental property depreciation works? Let us know your thoughts in the comments below.