The tax man cometh
It’s tax time…Again. And one of the great advantages of rental property investments is that they act as tax shelters. Hence, they save you from paying more in the way of taxes. One of the chief ways this is accomplished is through the usage of depreciation on each and every investment property you own. When you take the maximum allowed depreciation as deductions against your rental property net income (gross rents minus total expenses on any given property), you can effectively knock out most or all of your net income – on paper that is. When you do this, voila – no rental income to pay taxes on…And this is why rental investment property makes for such an excellent tax shelter.
Offsetting net income
Even though you may be showing a profit with a positive net income, taking depreciation each year allows you to eliminate that profit to avoid any tax liability. As an example of how this works, let’s say you earned $10,000 in rental income last year. However, you had expenses of $7,000. In theory, you had a net income of $3,000. But if your depreciation was $5,000 in this example, you would show, on paper, and more importantly to the Internal Revenue Service, a $2,000 loss. And that loss could also be claimed against other rental property net income, effectively reducing your overall tax bill.
The depreciation schedule
One of the key ingredients of taking this deduction, is your depreciation schedule. Think of depreciation as being comprised of two basic parts. Part one would be the purchase price of your investment property, less the “land” value. And part two would consist of any “capital” improvements you make to the rental property (that inherently add value to it, and become part of the building as a permanent, non-removable feature). So, consider any kitchen or bath rehab costs as elements that would go directly to this part two of capital improvements. Ultimately, these improvements will jack up the “cost” basis of your property. And your cost basis will be placed on a depreciation schedule.
Maximum useful life of a building
The IRS sets most property as having a useful life, for tax purposes, of 27.5 years. Thus, you can deduct as depreciation that percentage of the total building cost each year. The cost of a kitchen rehab, for example, would be placed on a separate depreciation schedule. Let’s say your tax professional recommends a 15 year depreciation for a new kitchen remodeling project. He’ll then deduct that as a separate portion of your depreciation. If the following year you add new flooring to the living room, for example, that would then be placed on another depreciation schedule just for the flooring.
Depreciation and maintenance do not mix
Remember that maintenance items (like snowplowing, grass cutting, plumbing repairs to name a few) are just that – maintenance, or repair items. And their full amount is expensed in the year the expense is incurred. There is no depreciation on repair work. When you fill out IRS form 4562 of your income tax, you will be detailing your exact depreciation for each rental property you own. In addition, you’ll be laying out the depreciation schedule for each and every improvement, based on the useful life of that improvement. Many investors and tax professionals like to use a depreciation calculator to ascertain the useful life of a given improvement. These depreciation calculations are simple enough to lay out and claim on the form. However, it’s always a smart idea to use a tax professional to actually figure out the depreciation to offset your net income, and then calculate and apply the actual sax savings for you.
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