With the nature of the business, military members are often on the move. This, along with some of the great VA Loan benefits, leads to many active duty military members and veterans becoming landlords and renting out houses in which they once lived. Investing in real estate offers unique financial opportunities for military members and veterans, providing a path to long-term wealth accumulation and financial security. However, navigating the complexities of rental property taxation is essential to maximizing returns and optimizing tax benefits. One powerful tool available to all real estate investors is depreciation, a tax deduction that can significantly reduce tax liabilities and enhance investment profitability.
Understanding Rental Property Depreciation
Rental property depreciation serves as a cornerstone of real estate investment taxation, allowing property owners to deduct a portion of the property's purchase price and improvement costs from their tax returns. This deduction acknowledges the wear and tear and loss of value inherent in rental property ownership, providing financial relief to investors. It is important to note that even if the market value for the property increases, the building and other structures can be depreciated for tax purposes. Understanding the fundamentals of depreciation is crucial for optimizing tax benefits and maximizing returns.
Key Takeaways for Military Investors
Rental property depreciation enables military members and veterans to deduct the property's purchase price and improvement costs from their tax returns, reducing overall tax liabilities-even if the property’s market value increases.
Depreciation commences as soon as the property is placed into service or available for use as a rental
By convention, most U.S. residential rental properties are depreciated at a rate of 3.636% annually for 27.5 years, offering consistent tax deductions over the property's useful life.
Military investors should note that only the value of buildings, not land, can be depreciated, and certain costs associated with land improvement activities may not qualify for depreciation.
How Rental Property Depreciation Works
Depreciable Property Criteria
According to IRS guidelines, rental property can be depreciated if it meets specific criteria, including ownership, use in business or income-producing activities, determinable useful life, and a duration of more than one year. For military members and veterans considering real estate investment, understanding the IRS requirements for depreciable property is essential for maximizing tax benefits and compliance with tax regulations. Note that the depreciation is specific to the dwelling and other structures and excludes the land, as the land will not get worn or used up.
Commencement of Depreciation for Military Investors
Depreciation begins as soon as the rental property is placed into service or ready for use as a rental, offering immediate tax benefits to military investors. If you are PCSing and turning your home into a rental, this means the depreciation would begin once the house is ready to be rented, likely once you’re moved out or complete any maintenance after you have moved. Whether purchasing a property for rental income or converting a primary residence into a rental property due to military relocation, understanding the timing of depreciation commencement is critical for optimizing tax planning strategies.
Depreciation Systems and Methods
Residential rental properties placed in service after 1986 are depreciated using the Modified Accelerated Cost Recovery System (MACRS), offering military investors flexibility in choosing the depreciation method. Investors may opt for the General Depreciation System (GDS) or the Alternative Depreciation System (ADS), depending on their specific circumstances and tax planning objectives. GDS is the most common deprecation application and will generally be the employed for military landlords converting a home to a rental property. ADS is mandated when the property meets certain criteria, including: has qualified for business use for less than 50% of the time, has a tax-exempt use, is financed by tax-exempt bonds, or is used primarily in farming. Understanding the nuances of each depreciation system empowers military investors to make informed decisions and maximize tax benefits.
The GDS method
The General Depreciation System (GDS) is a method used by taxpayers, including military members and veterans, to calculate the depreciation of residential rental properties for tax purposes. Under GDS, the recovery period for residential rental property is set at 27.5 years. This means that the property's value is depreciated over a period of 27.5 years to account for wear and tear and loss of value.
When applying GDS, the depreciation amount for each year is determined based on a fixed percentage of the property's adjusted basis. For most residential rental properties, this percentage is 3.636% per year. However, if the property is placed in service for less than a full year, the depreciation amount for that year is prorated based on the month the property was placed in service.
For example, if a rental property was placed in service on April 30th, or 1/3 of the year, the depreciation rate for the first year would be 2.431% [3.636% x (1-(121/365))] of the property's adjusted basis. In subsequent years, the depreciation rate would be the full 3.636% of the adjusted basis.
To illustrate, let's consider a rental house with an adjusted basis of $200,000. Using the example above, the depreciation for the first year would be $4,862 [$200,000 x 2.431%], and for subsequent years, it would be $7,272 [$99,000 x 3.636%].
Determining the basis
The process of determining the basis of a property is essential for accurate depreciation calculation and tax reporting. The basis represents the total amount paid to acquire the property, including various expenses incurred during the acquisition process. These expenses typically include settlement fees, closing costs, legal fees, recording fees, surveys, transfer taxes, title insurance, and any agreed-upon payments such as back taxes.
However, it's crucial to note that not all settlement fees and closing costs can be included in the basis. Expenses like fire insurance premiums, rent for tenancy before closing, and charges related to loan acquisition or refinancing, such as points, mortgage insurance premiums, credit report costs, and appraisal fees, are excluded from the basis calculation.
For example, let's consider a scenario where a property is purchased for $250,000. To determine the basis, one would need to utilize the latest real estate tax assessment, typically obtained from the county's tax office. If the assessment indicates that 85% of the total value pertains to the building and improvements, while the remaining 15% is allocated to the land, the basis for the property would be calculated accordingly. In this case, the basis for the building and improvements would be $212,500 [$250,000 x .85].
After establishing the basis, adjustments may need to be made to arrive at the adjusted basis, which is used for depreciation calculation. These adjustments account for events that occur between the property's acquisition and its readiness for rental.
Increases to the basis may occur due to expenditures on additions or improvements with a useful life of at least one year, restoration of damaged property, utility service installation, and certain legal fees. Conversely, decreases to the basis may result from insurance payments received for damage or theft, casualty losses not covered by insurance, or payments received for granting easements.
Overall, determining the adjusted basis requires careful consideration of various factors and expenses incurred throughout the property ownership journey. By accurately calculating the adjusted basis, property owners, including military members and veterans, can ensure compliance with tax regulations and optimize their depreciation deductions for rental properties.
Conclusion: Maximizing Tax Benefits for Military Investors
Rental property depreciation presents a valuable tax-saving opportunity for military members and veterans venturing into real estate investment. By understanding the intricacies of depreciation rules, timing, and methods, military investors can unlock significant tax benefits and enhance investment profitability. Leveraging depreciation, along with allowable deductions and strategic tax planning, empowers military investors to optimize tax efficiency, minimize tax liabilities, and build wealth through real estate investment. For personalized guidance and tailored tax strategies, military investors are encouraged to consult with experienced tax professionals specializing in real estate taxation and military financial planning. With informed decision-making and proactive tax planning, military investors can harness the full potential of rental property depreciation to achieve their financial goals and secure a brighter future for themselves and their families.
Eligible service members and spouses have access to MilTax free tax filing and prep services. For additional information visit Military One Source’s taxes page.
