Depreciation of Rental Property?

Question

I had a co-worker tell me that my income from my rental should be tax free because of depreciation of the house. Can anyone better explain this to me? I thought that houses appreciate?

Answer 1

Any year for which your deductions from the rental are more than your rental income, then you will pay no tax on the rental income that year.

One of the deductions is depreciation, which is a fraction of the basis (usually the cost) of the structure (not the land).  For example, if your structure cost you $275,000, you may be able to deduct $10,000 each full year.  You depreciate the property over 27.5 years.

So suppose you did this for ten years, and have taken $100,000 of depreciation.  Then you sell the property for the same amount that you paid for it, $275,000 for the structure, and the land for the same price as well.  You have to reduce the basis in your house to $175,000.  So even though you have no profit on your house, you have to pay tax on a gain of $100,000.  This is the "recapture" of depreciation.

If you never sell the house, then you escape this recapture.

If your property increases in value, then when you sell you have to recapture depreciation as well as pay tax on the rest of the gain (capital gain).

For more information, read the IRS Publication 527 Residential Rental Property

http://www.irs.gov/pub/irs-pdf/p527.pdf

Answer 2

Even though houses do appreciate over the long term, you are allowed to claim a depreciation deduction on the home the same as any other business asset.  Because of this, most rental property creates a tax loss every year for the owner.  However, you must recapture the depreciation when you sell the property.