What is the annual depreciation allowance?
Not all real estate investors know this, but you can deduct the amount it cost you to purchase and renovate a property from your tax return. The result? You can reduce your tax liability and potentially save thousands of dollars. It’s called depreciation—the process of deducting costs associated with property as it decreases in value over time. The most successful real estate investors use depreciation to reduce the amount of taxes they pay, and you could possibly do the same.
An annual depreciation allowance is the amount a tax authority allows taxpayers to deduct annually from their income if an asset is defined as depreciable. In the United States, the IRS allows homeowners and investors to reduce the amount of taxes they pay for a property that will eventually decrease in value, making it harder to sell and costlier to renovate. That’s because most properties, no matter how grand, will deteriorate or suffer wear and tear in the years and decades after it’s built. While land doesn’t deteriorate and therefore can’t be depreciated, a building is considered by the IRS to have a shelf life!
The IRS allows depreciation on a building (also called “land improvement”) so homeowners and investors can deduct the cost of the building of the purchased real property on their tax returns. This is another one of those important things that they don’t teach you in school. If you want to benefit from the annual depreciation allowance, you need to claim it on IRS form 4562.
Depreciation is spread out over the useful life of the asset which is determined by the Internal Revenue Code. For example, a residential property is only “good” for 27.5 years and a non-residential property for 39 years.
To calculate your annual depreciation allowance, use the following calculation. It’s surprisingly simple.
Annual depreciation allowance = depreciable basis / useful life
The depreciable basis is the original value of the land improvement, which should be equal to the cost of the real property minus the cost of the land improvement; and the useful life is either 27.5 or 39 years, depending on the property type.
Annual depreciation allowance case study
A real estate investor purchased a residential property for rental purposes five years ago on January 1. The value of the land on the foreclosure date was $100,000 and his total spending on the residential property amounted to $1M. To calculate the depreciable basis of the building, he subtracts the value of the land by the total cost of the property ($1,000,000 – $100,000 = $900,000). Then he divides that amount by the property’s useful life, which is 27.5 years. His annual depreciation allowance of this residential property is $32,727 ($900,000 / 27.5 = $32,727). For the past five years, he claims this amount on IRS form 4562 annually and reduces his tax liability.
The bottom line
Annual depreciation allowance is a lot less complicated than it seems! It allows investors and homeowners to pay less tax for a business property that will depreciate in value over time. It can help you recoup some of your losses as your property deteriorates and suffers wear and tear. In the U.S., you can claim depreciation on the form 4562.