Depreciation is what makes rental real estate one of the most tax-efficient investment vehicles available. The IRS allows investors to deduct the cost of improvements to a property over its useful life, reducing taxable rental income each year without any additional cash outlay. Understanding this concept helps MLOs better qualify investor borrowers and explain rental income scenarios.
The 27.5-Year Schedule for Residential Property
Residential rental properties are depreciated over 27.5 years using the straight-line method. Only the improvements (structures) are depreciable; land is not. If a property costs $400,000 and the land value is $75,000, the depreciable basis is $325,000. Annual depreciation is $325,000 divided by 27.5, which equals approximately $11,818 per year. This reduces taxable rental income by that amount each year even if the property is cash-flowing positively.
Passive Activity Loss Rules
Rental losses generated by depreciation are generally classified as passive losses under IRS rules. Passive losses can only be deducted against passive income from other sources. They cannot be used to offset W-2 wages or active business income for most taxpayers. There is a limited exception for taxpayers who actively manage their rental properties and have modified AGI below $100,000: they can deduct up to $25,000 of passive rental losses annually, with the allowance phasing out between $100,000 and $150,000 AGI.
Depreciation Recapture on Sale
When a rental property is sold, the IRS recaptures accumulated depreciation. The recaptured amount is taxed at a maximum rate of 25%, not at the lower long-term capital gains rates that apply to appreciation. Investors who have held a property for many years can face a substantial recapture tax. Understanding this helps MLOs explain why a 1031 exchange is valuable for investors who want to defer both capital gains and depreciation recapture.
- ✦Residential: 27.5-year straight-line depreciation on improvements
- ✦Commercial: 39-year straight-line depreciation on improvements
- ✦Depreciation recapture: taxed at maximum 25% rate upon sale; not at capital gains rates
- ✦1031 exchange: defers both capital gains tax and depreciation recapture when reinvesting in like-kind property
Aria can help you understand how depreciation affects rental income qualifying calculations for investors and how lenders treat paper losses on tax returns. Ask at vicariointel.com.
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