While depreciation is generally viewed as negative -- especially when it comes to quickly-aging assets like vehicles -- in the investment property context, depreciation is key to lowering your tax bill. However, for those who don't have much experience in rental real estate or real estate taxes, the idea of depreciation and tax depreciation reports can seem overwhelming. Once you've purchased your property and put it into rental or lease service, where should you begin? Read on to learn more about depreciating your new investment property.
What is the practical effect of depreciation of rental or investment real estate?
Depreciating a property allows you to deduct a certain percentage of its value from your gross rental receipts, lowering your tax liability for the rent you've collected and freeing up more cash to perform capital improvements (like installing a new roof, metering the water in multi-family homes or apartment buildings, or repaving a parking lot.) Taking advantage of this depreciation for each year in which it is available can, over time, significantly increase your take-home rents; in theory, this frees up even more funds to invest in additional rental properties.
What types of depreciation are available for your property?
There are several types of depreciation for which your property could be eligible, and all of these are designed to maximize the tax breaks available for those who invest in real estate.
The capital works deduction is more commonly known as the "building write-off," and refers to the building's structural elements -- roofing, drywall, flooring, and even fixtures like bathtubs, sinks, and doors. These deductions allow you to recapture 2.5 percent of your home's value for a total of 40 years -- likely long after you've paid off any mortgage or other loan associated with the property.
It's important to note that the 2.5 percent capital works deduction applies only to residential property, not commercial buildings. Whether a specific piece of real estate qualifies as residential or commercial depends largely on zoning laws and actual use; for example, a complex that includes restaurants and retail stores but also has upstairs apartments will probably fall on the commercial side of the equation, while an apartment building that has only a single small coffee shop in the lobby is far more likely to be deemed residential.
For commercial properties, the plant and equipment deduction is more likely to come into play. This depreciation schedule allows owners to depreciate the value of removable capital assets, like mechanical equipment, and stands in contrast to the residential depreciation schedule, which applies only to not-easily-removed fixtures. For most rental properties, the capital works deduction will provide the biggest bang for one's Aussie buck.