How to Calculate Your Vacation Rental Property Depreciation

If you are in the market for a vacation rental property or are already in the process of purchasing one, it’s likely you’re aware of the significant deductions you can make to your taxable income. Real estate depreciation is an important tool for rental property owners, and since we understand how complex certain tax rules can be when it comes to real estate, we’re going to help walk you through it in this blog.

What is Rental Property Depreciation?

Depreciation is the process used to deduct the costs of buying and improving a rental property. Rather than taking one large deduction in the year you buy (or improve) the property, depreciation distributes the deduction across the useful life (27.5 years) of the property. The amount you can deduct will depend on a few things, such as your basis in the property, the recovery period, and the depreciation method that is used.

Requirements for Depreciation

The internal Revenue Service (IRS) has specific rules when it comes to depreciation that rental property owners should be aware of. In order to depreciate a rental property, the following requirements must be met:

  • You own the property
  • You use the property in your business or as an income-producing activity
  • The property has a determinable useful life, meaning it loses value from natural causes over time
  • The property’s life expectancy is over a year

It’s important to note that even if a property meets all of the above requirements, it can’t be depreciated if you no longer use it for business use in the same year (generate rental income). Additionally, land isn’t considered depreciable either, so the cost of planting, clearing or landscaping does not fall into the category of depreciation, as that is considered a cost of the land, not the building.

How to Calculate Depreciation

There are three factors that determine the amount of depreciation you can deduct each year:

Your basis in the property, the recovery period, and the depreciation method used.

Residential rental property placed in service after 1986 is depreciated using the Modified Accelerated Cost Recovery System (MACRS), which spreads the costs and depreciation deductions over the useful life of a rental property. Though it’s always recommended to work with a qualified tax accountant when calculating depreciation, here are the basic steps:

Determine the Basis of the Property

The basis of the property is the cost or amount you paid to acquire it. The following are certain costs that can be included in the basis:

  • The sales tax when you bought the property (unless you deducted state and local general sales tax on the Schedule A/Form 1040 as an itemized deduction)
  • Installation/testing charges
  • Settlement costs such as legal fees, transfer taxes, title insurance, back taxes, etc.

Some settlement fees that can’t be included in your basis include fire insurance premiums, rent for tenancy of the property before closing, or any charges connected related to getting or refinancing a loan such as mortgage insurance premiums, credit report cost or appraisal fees.

Determine the Cost of Land vs. the Rental

Since you can only depreciate the cost of the building and not the land, you must determine the value of each to depreciate the correct amount. To do this, you can use the fair market value of the property when you bought it, or the assessed real estate tax values. For example, say you bought a house for $110,000, but its valued at $90,000, of which $81,000 is for the house and $9,000 is for the land, you can then allocate 90% ($81,000 ¸ $90,000) of the purchase price to the house and 10% ($9,000 ¸ $90,000) of the purchase price to the land.

Calculate the Basis of the Rental

As we mentioned above, the basis of the property is the amount you paid. Using the above example, we can determine the basis of the rental by calculating 90% of $110,000. So, the basis of the property (the amount that can be depreciated) would be $99,000.

If you wanted to calculate the amount that can be depreciated each year, you’d take the basis and divide it by the 27.5 year recovery period: $99,000 ¸ 27.5 = $3,600 per year.

The Bottom Line

Depreciation is a valuable tool for rental property owners as it allows you to spread the cost of buying over time, and reduce your yearly tax bill. While this hopefully gave you a better understanding of depreciation, it’s always recommended to consult a professional tax advisor when determining tax deductions for your rental property.

Looking to Finance Your Next Vacation Rental Property?

Here at RCN Capital, we can help you find financing options for the vacation rental property of your dreams. If you’re looking to invest in property to generate rental income, RCN has you covered. Reach out today to learn more about our loan programs.