It is an annual allowance for the wear and tear, deterioration, or obsolescence of the property.
Most types of tangible property (except, land), such as buildings, machinery, vehicles, furniture, and equipment are depreciable. Likewise, certain intangible property, such as patents, copyrights, and computer software is depreciable.
Most people divvy up the cost of their rental real estate into land and improvement, or building, for depreciation. If you do it that way, you may be missing large deductions.
Here’s how you can save and make some money that you may not have before.
Start with this year. If you bought the investment real estate this year, consider having an expert evaluate your property piece by piece in what’s called a cost-segregation or component-evaluation analysis. Each piece of your building is put into various categories, each with different depreciation timelines. You may also be able to get a pretty good estimate of its depreciable value on your own.
If, instead, you depreciate your building and its contents as a whole, you’re forced to do that over 27-1/2 years for residential rental property and 39 years for a commercial property.
By using a cost segregation analysis, you can depreciate parts of the building over a much shorter lifespan.
First, divide the purchase price of the property into real and personal property (such as refrigerators, dishwashers, carpeting, etc.), then depreciate that property over the period of time allowed by the IRS.
Second, break out the property improvements, such as paving, fences, landscaping, underground pipes, etc. Depreciate them over a 15-year period.
Third, take the remaining value, less the raw land, and depreciate that over a 27.5year period.
Even when you divide the property between raw land and improvements, you could be cheating yourself. Too often property owners use the percentage of value the county tax assessor puts on the land as its value. Remember, the land has pipes running under it, both water and sewer, and it may have a septic tank.
The best way to establish the depreciable value is the comparable sales method: what have other lots of a size similar to yours sold for in the area? These would be lots without improvements, such as fences and outbuildings. The average of those values is the figure you would use for the land. Subtract it from the total sale price of the property.
Here is a synopsis of personal-property depreciation timelines:
1. 5-year property.
a. Automobiles, taxis, buses, and trucks.
b. Computers and peripheral equipment.
c. Office machinery (such as typewriters, calculators, and copiers).
d. Appliances, carpets, furniture, etc., used in a residential rental real estate activity.
e. Certain geothermal, solar, and wind energy property.
2. 7-year property.
a. Office furniture and fixtures (such as desks, files, and safes).
b. Agricultural machinery and equipment.
c. Any property that does not have a class life and has not been designated by law as being in any other class.
3. 15-year property
a. fences, walkways, driveways
b. shrubbery
c. underground pipes
In order for you to be allowed a depreciation deduction for a property, the property must meet all the following requirements:
• You must own the property. However, you may also depreciate any capital improvements for property you lease.
• You must use the property in business or in an income-producing activity. If you use a property for business and for personal purposes, you may only deduct depreciation based only on the business use of that property.
• The property must have a determinable useful life of more than one year.
Even if you meet the preceding requirements for a property, you cannot depreciate the following property:
• Property placed in service and disposed of in same year.
• Equipment used to build capital improvements. A taxpayer must add otherwise allowable depreciation on the equipment during the period of construction to the basis of the improvements. For example, if you bought a band saw to cut lumber for adding a room onto a rental property, you may not depreciate it in the year you built the add-on.
If you think you missed your chance
Few of us bought all of our properties last year, but you haven’t missed out on these depreciation deductions. All you have to do is file a form with the IRS that explains “I messed up and didn’t segregate my depreciation.” You will want to hire a tax professional to do that, though.
