The Rental Property Depreciation Allowance Calculation

Rental property depreciation (also known as cost recovery) is one of the biggest tax deduction benefits real estate investors enjoy by owning rental properties.

The beauty of the rental property depreciation allowance lies in the fact that it is simply a “paper loss” the real estate investor can write off during each year the rental property is owned without having to shell a dime from out of pocket.

The investor can legally deduct an amount for depreciation as cost recovery each year from the cash flow he or she collected from the asset during the past twelve months of ownership and therein lower his or her tax liability for that past year. But unlike say, mortgage interest (which is also a legal tax deduction), real estate investors never have to fork out any money for depreciation on rental property.

In this article, we will discuss rental property depreciation; including its concept, limits, application, and formula.

The concept behind a tax depreciation deduction is based upon a principal known as “useful life”. The idea is straightforward. That no matter how grand and prestigious a building may be when it’s constructed, any physical structure does have a physical life and will eventually wear out, deteriorate, or become obsolescent. In other words, brick and mortar is finite and realistically can only last for so many years.

Furthermore (as a result of this deterioration), the owner therefore is suffering a financial loss by owning the property (because it is deteriorating) and as such should be granted the benefit to “recover the cost” from his or her income taxes as a result of the property’s diminishing useful life.

This is the purpose for IRS form 4562. So an owner of rental income property can claim a tax depreciation deduction on any rental properties that he or she has owned for the past twelve months.

Fair enough. So let’s consider some of the limitations the IRS has in place for real estate investors who attempt to get this tax deduction for the rental income properties they own.

In order for a taxpayer to be allowed to take a rental property depreciation deduction, the property must at least meet the following requirements:

  • A taxpayer must use the property in business or in an income-producing activity (a personal residence doesn’t count).
  • The property must have a determinable useful life of more than one year.
  • The property cannot be placed in service and disposed of in same year.

Likewise, the tax deduction for depreciation only applies to the physical structures (called “improvements”) of the property, not to the land. There is no cost recovery allowance for the value of the land.

What’s more, the depreciation begins when a taxpayer places property in service for use for the production of income (i.e., takes title) and ceases to be depreciable when the taxpayer has fully recovered the property’s cost or other basis or when the taxpayer retires it from service (i.e., transfers title); whichever happens first. In other words, you will not get a tax depreciation deduction for your income property past its “useful life”, nor after you sell it.

Okay, so what does “useful life” signify?

Useful life is a term used by the IRS to specify the number of useful years it attributes to rental property in order to arrive at the depreciation deduction allowable. The useful life is strictly used for tax purposes only, however, and does not necessarily imply the actual physical life expectancy of the physical asset. In this case, the tax code currently regards the useful life for residential property as 27.5 years and for nonresidential property as 39 years.

For instance, a building that derives all or nearly all (80% or more) of its income from dwelling units such as single-family homes, multi-families, apartment buildings, condos and so forth is residential and thus can be depreciated 27.5 years. Property that derives its income from non-residential sources such as offices, retail space and industrial tenants is nonresidential and thus depreciated 39 years.

Here’s the computation.

For our purposes, we will refer to an annual depreciation allowance and ignore what the tax code calls the “mid-month convention.” This convention applies to the year the asset is placed into service and whatever year it is disposed and states that you are allowed to take only one-half of the depreciation normally allowed for whatever month the property is purchased and then subsequently sold. We are dealing only with the depreciation tax allowance taken annually during the holding period in between purchase and sale.

First, determine the depreciable basis. This is essentially the original value of the rental property improvements (remember, you cannot depreciate land). Then divide that depreciable basis by what the current tax code attributes to the rental property’s useful life.

Depreciation Allowance (annual) = Depreciable Basis / Useful Life

For example, say you purchased a duplex thirteen months ago for $500,000 of which you attribute $400,000 to the building and $100,000 to the land. What is your annual depreciation allowance?

In this case the depreciable basis is $400,000, the useful life is 27.5 years because this is residential property, and since it is not in either the year of purchase or sale the mid-month convention is not applicable.

Depreciation Allowance (annual) = Depreciable Basis / Useful Life
Depreciation Allowance (annual) = 400,000 / 27.5 = 14,545

Of course, there is much more to rental property depreciation then we have discussed here such as capitalized costs of acquisition and additions or capital improvements to the property. But hopefully you have gotten the idea. Naturally, we strongly recommend that you always consult a qualified tax person before making any real estate investment decisions.

Just so you know. Rental property depreciation is only one of dozens of real estate calculations that can be made and learned with the online real estate calculator developed for this purpose.

Rental Property Management Made Easy

Having your own rental property management plan is key to residential rental property investing.

Its 8:30 at night, your tenant calls and says water is leaking very badly under the sink. Its 8:30 at night, your tenant calls and says the toilets clogged. Its 8:30 at night, your tenant calls and says a window just got smashed. Its 8:30 at night, your tenant calls and says the roofs leaking. Its 8:30 at night, your tenant calls and says the heats not working. Its 8:30 at night, your tenant calls and says the bedroom doorknob fell off.

How about a gutter gets disconnected. No big deal, when it rains make sure your not standing underneath it. Winter comes, where water hits the ground, it starts to collect and then it freezes. Whoops, someone slips there and you get sued. Big problem. It pays to have a rental property management plan.

How about that exterior porch wood that needs painting. No big deal. Next year. Next year comes and goes and you saved 700 bucks not doing it. Three years later you spend $2000 having wood replaced because its to rotted. Big problem. It pays to have a property management plan.

You get the idea, whether something breaks or routine maintenance – things need to get fixed and maintained.  A good rental property management plan helps ensure easy and profitable multifamily property investing.

There are three main factors for a good rental property management plan. Knowing who is responsible for managing the properties maintenance, who is going to fix things and when will things get fixed  are the three main factors.  Having a game plan for these three things is vital for maintaining your rentals. Theses three factors should be addressed and included in the lease. This ensures the tenant knows ahead of time what to expect when things need repairing or maintenance.

Lets start with who will be responsible for managing your rental property.  Seventeen years experience of owning rentals has taught me that know one else will be better than the property owner for being  responsible for managing the maintenance of your rental units. So the most cost effective rental property management plan has the owner doing the managing.

Before you say, oh god, what a nightmare managing rental property is, let me say I have learned and you can too, how to make property management simple and profitable.

In fact, for those who understand and implement  a solid rental management plan correctly and continue investing wisely in cash flowing residential multifamily properties will find that their hourly pay time for managing  their rental properties is extremely lucrative.

Needless to say, I personally strongly advise against hiring a management company for residential rental property.

Lets address who is actually going to be fixing  broken items or doing the required maintenance?

You, the owner, your payroll help, a hired handyman, who is going to actually be doing the physical work for fixing and maintaining your rental units. Why is it important to have this be part of your rental property management plan?

Well, what you don’t want is having every time something needs to be repaired become a stressful costly headache.

By knowing who is going to be doing the repairs  ahead of time, through your rental maintenance plan, you eliminate two potential problems.

One, when a problem does occur, your somewhat prepared by having had developed a list of contacts ahead of time. Secondly, being prepared like this, tremendously reduces stress and makes managing your rental property easy.

Hopefully you see the importance of knowing ahead of time who is responsible for and who is actually going to be doing the maintenance work. 

Later, I’ll tell you the third important key for a cost effective, easy to implement  rental property management plan.

A few additional things to consider regarding rental property management. If your just starting out and you buy a multifamily house, and your a  hands on type person you may want to do as much of the maintenance and repairs as possible.

If you go on to keep investing in multifamily houses you’ll find actually doing the physical maintaining of your income properties to burdensome.

Understand that managing rental properties and doing the physical work are two different things.

If you decide to hire a maintenance man or handyman to do the maintenance, ask around local hardware stores for referrals or ask people in a Home depot or Lowes. They’re not supposed to refer people but I have been pleasantly surprised how many people moonlight or know someone fair priced and reliable.

Look in a local paper for a handy man you can enlist to do the maintenance. Call a few people placing adds, not big print adds, rather the small adds and tell them what kind of help your looking for. Listen to them give their spiel, ask questions and ask if they can offer you anyone who they worked for in past as a recommendation. If they check out tell them you’ll be giving them a call when you need them.

Personally, I do not recommend hiring an outside company to do your rental property management.

Another great place to get names of reliable people to do your repairs and maintenance is through your local REIA group. The more names and numbers for cost effective, reliable maintenance men, the better. Put their names, numbers and what they do into your cell phone or keep them in a special book. I’m sure I’m not the first or last person to put a name and number in a book and later not remember who they are or what they do!

Who might you want to have on your rental property maintenance list before you even need them? A few general handymen, a furnace repair man unless you  want to get repair contracts from the gas company if your property heats by gas, an exterminator ( I actually have contracts for quarterly prevention with exterminator on all my units), an appliance repair man if you supply appliances, a plumber, a drain cleaning company and someone to shovel or plow your dwellings.

If you went on to own a lot of multifamily units, you may want to considering hiring someone on full time for doing the physical maintenance work. Personally I prefer having a large network of contacts I can call on for maintenance and repair work over having employees.

If you follow these rental property management guidelines, managing your cash flow units is simply a very profitable job of receiving and making phone calls.

Earlier I mention there was one more important factor to address regarding how to manage your rentals.y.

When will things be repaired?  Put in the lease or addendum how long you have to make arrangements to have things fixed, twenty four, forty eight, seventy two hours? Put it in the lease so tenant knows how you maintain your property. It may seem silly, but I’ve found by having the tenants being aware of how you manage and maintain your rentals the less misunderstandings you’ll have.

Remember, your in charge. Its your property and having a solid rental property  plan and informing your tenants how you maintain your rental property will make owning investment property all the better.

As they say in the hood, everyone knows what time it is.

How to Find a Good Rental Property Agent

If you are new to rental property investing, the first person you will need on your team is a real estate agent. A good real estate agent is the most important person on your team because he/she will be the one that:

  • Makes you aware of what rental properties are available for sale, and coordinates the showings.
  • Helps educate you on the details of the business as it relates to the local market (the best streets in the neighborhood, advice for handling tenants, etc.).
  • Provides referrals of professionals you will need as your investment activity progresses.
  • Coordinates the buy & sell transactions, including all negotiating, closing requirements, and associated documentation.

Requirements of a Good Rental Property Agent

You’ll want an agent that specializes in investment properties because this segment of the market is dramatically different than the primary residence segment. First and foremost, the negotiating strategy is different. For example, investors are generally more patient than homeowners in terms of waiting for the best offer, as they are bringing in rental income. Therefore, the sense of urgency is lower than for someone who, for example, must sell his home due to job relocation. Similarly, much of the emotional element of the transaction is eliminated when buying or selling rental property, because in these cases the numbers are king.

Additionally, you’ll find that an agent who specializes in rental properties tends to have access to “hidden” listings, as their selling clients are also likely to be investors, and it’s in the best interest of the agent to have both the buyer and seller of the transaction be his/her clients in order to maximize his/her commission.

Also, when looking at rental properties, you’ll have to work around tenant’s schedules, and having an agent that knows how to communicate with tenants can help in many situations. For example, if the tenant is unaware of the appointment and you essentially just “show up” without the tenant’s knowledge, an agent skilled in pacifying the tenant so that you can view the property while you are already there will save you a lot of aggravation.

Where to Find a Good Agent

To find a good real estate agent that specializes in rental properties, you’ll have to do a little prospecting. Here is what I recommend: visit realtor.com and do a search for investment properties within your market. The realtor.com listings do not provide the names of specific agents, but they do provide names and phone numbers of listing offices.

Within your search results, count the number of investment property listings per real estate office. Call the listing office that has the most properties for sale and say that you saw a property that you would like to inquire about. You will be transferred to the listing agent, who likely will be the primary investment property agent within that specific office. Tell that person you are looking to buy rental properties for investment purposes, and simply ask if you can be their client.

Working with Your New Agent

Ask your new agent to send you all the active rental property listings in your target area. Then you can run some numbers, do some drive-bys, and ultimately set up time to physically inspect the top few possibilities from the full list.

If you ultimately find that you do not like working with the agent, just rinse and repeat via realtor.com. I have never been bound by any kind of exclusivity arrangement with an agent for just looking at properties, so you can always move on to another agent if necessary.