Depreciating Properties: A Guide to IRS Publication 946

When it comes to managing real estate investments, understanding tax implications is crucial. One of the most significant tax benefits for property owners is depreciation, and IRS Publication 946, How to Depreciate Property, is the go-to resource for navigating this process. This guide provides an overview of what you need to know about IRS Publication 946 and how it applies to your real estate investments.

Main Highlights

• Depreciation lets property owners recover costs of income-producing assets, reducing taxable income and boosting cash flow.
• IRS Publication 946 is an essential guide to depreciation rules, helping investors and businesses optimize tax benefits.
• Accurate records and IRS compliance are key to avoiding issues and maximizing depreciation tax savings.
• Cost segregation and understanding depreciation recapture, improvements, and repairs can enhance a real estate investor's tax strategy.

Table of Contents

• Main Highlights
• What is IRS Publication 946?
• What is Depreciation?
• Property That Can Be Depreciated
• Property That Cannot Be Depreciated
• Key Concepts in IRS Publication 946
• Steps to Calculate Depreciation
• Special Considerations for Real Estate Investors
• Conclusion

What is IRS Publication 946?

IRS Publication 946 is a key resource for understanding property depreciation for tax purposes. It outlines the rules, methods, and regulations for depreciating assets, including rental properties, machinery, and other depreciable assets. This guide simplifies complex accounting concepts with clear definitions, examples, and practical applications, making it accessible for both seasoned investors and first-time property owners.

The publication highlights the importance of accurate record-keeping and compliance with IRS regulations to avoid issues and optimize tax deductions. By adhering to these guidelines, taxpayers can effectively navigate the complexities of property depreciation and maximize their tax benefits.

What is Depreciation?

Depreciation is a tax deduction that allows property owners to recover the cost of income-producing property over time. It accounts for wear and tear, deterioration, or obsolescence of the property. Depreciation reduces your taxable income, making it a valuable tool for real estate investors.

To claim depreciation, the property must meet these criteria:

1. You own the property.
2. The property is used in your business or income-producing activity.
3. The property has a determinable useful life.
4. The property is expected to last more than one year.

Property That Can Be Depreciated 

Business Property: This includes assets used in a trade or business, such as buildings, equipment, and vehicles.

Rental Property: Real estate used for rental purposes can be depreciated.

Leased Property: If you lease property to others, you can depreciate it.

Property Used in Research and Experiments: Assets used for research and experimentation in a trade or business can be depreciated.

Property That Cannot Be Depreciated

Land: Land is not depreciable because it does not wear out or become obsolete.

Personal Property: Items used for personal purposes, such as your home, personal car, or personal electronics, cannot be depreciated.

Inventory: Items held for sale to customers are not depreciable.

Property Held for Sale to Customers: This includes items that are part of your inventory.

Key Concepts in IRS Publication 946

IRS Publication 946 outlines several methods for calculating depreciation. The most common method for real estate is the Modified Accelerated Cost Recovery System (MACRS), which offers two systems:

• General Depreciation System (GDS): Used for most properties and allows for faster depreciation.
• Alternative Depreciation System (ADS): Used in specific cases, such as tax-exempt use property or property used predominantly outside the U.S

Depreciation Recovery Periods

• 3-Year Property: Examples include certain livestock and racehorses.
• 5-Year Property: Examples include cars, light trucks, and office equipment.
• 7-Year Property: Examples include office furniture and fixtures.
• 10-Year Property: Examples include boats and single-purpose agricultural or horticultural structures.
• 15-Year Property: Examples include improvements to land, such as fences and paving.
• 20-Year Property: Examples include farm buildings and certain municipal sewers.
• 25-Year Property: Examples include certain water transportation property.
• 27.5-Year Property: Residential rental property.
• 39-Year Property: Nonresidential real property.

Placed In-Service Date - Depreciation begins when the property is ready and available for use in your business. This date is critical for calculating your deductions accurately.

Section 179 Deduction and Bonus Depreciation

• Section 179 Deduction: Allows you to deduct the full cost of qualifying property in the year it’s placed in service, subject to limits.

• Bonus Depreciation: Provides an additional first-year depreciation deduction for qualifying property.

Steps to Calculate Depreciation

1. Determine the Basis of Your Property The basis is typically the purchase price plus costs such as closing fees, legal fees, and improvements.
2. Allocate the Basis Between Land and Building Land is not depreciable, so you must allocate the total basis between land and building based on their respective fair market values.
3. Select the Depreciation Method and Recovery Period Use GDS or ADS based on your property type and situation.
4. Calculate the Annual Depreciation Deduction Follow the IRS’s depreciation tables and guidelines to compute your deduction.

Special Considerations for Real Estate Investors

1. Cost Segregation Studies For real estate investors, cost segregation can accelerate depreciation deductions by identifying components of a property that qualify for shorter recovery periods, such as fixtures, HVAC systems, and landscaping.
2. Recapture of Depreciation When you sell a property, the IRS requires you to "recapture" depreciation deductions, which may result in a higher taxable gain. Understanding this rule is essential for planning your exit strategy.
3. Improvements vs. Repairs Improvements must be depreciated, while repairs can often be deducted in the year incurred. Knowing the difference can significantly impact your tax liability.

Conclusion

IRS Publication 946 is a valuable resource for understanding how to depreciate property and maximize your tax benefits. By familiarizing yourself with its guidelines, you can make informed decisions and ensure compliance with tax laws. For more complex situations, consulting with a tax professional or leveraging cost segregation studies can further enhance your strategy.