taxes

Investor can take depreciation expense and other deductions for rental property

Judy O'ConnorDear Tax Talk,
If you cannot deduct your mortgage payments for a rental property, then what is the point of having a mortgage? How are you supposed to get ahead? So let's pay Uncle Sam now so he can support me later? What a joke. I am thinking that paying all cash for the rental property is a better way to go.
-- Kathryn

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Dear Kathryn,
As a homeowner, you deduct your mortgage interest on Schedule A. As a rental property owner, you deduct your mortgage interest on Schedule E. Mortgage payments are otherwise not deductible

However, you have not factored into your equation the tax deduction for "depreciation" on the rental property. It really makes no difference whether you pay all cash for a property or finance it with a mortgage. You are still required to deduct on your tax return the depreciation, which is a portion of the cost of the property, on a yearly basis.

What is depreciation expense?

Taxpayers must recover the cost of rental property through an income tax deduction called "depreciation." This annual allowance accounts for a property's wear and tear.

Residential rental property can be depreciated in one of two ways:

  • Over a period of 27 1/2 years under the general depreciation system.
  • Over 40 years using the alternative depreciation system.

If you don't claim the depreciation expense, you still must recapture it when the property is sold. Depreciation recapture requires the seller to add the prior depreciation expense amounts to the sale price.

The depreciation expense is calculated based on your "basis," which is generally but not always your cost, the depreciation method used and the amount of time allowed by the IRS for your particular type of rental property. For further details regarding these concepts, please refer to IRS Publication 527, Residential Rental Property, which has an entire chapter devoted to this very important tax deduction. I strongly suggest that you, as a rental property owner, become more familiar with not only depreciation, but all of the requirements for reporting your rental income and expenses correctly on your tax return.

Many people find that they are unable to pay all cash when purchasing real estate, so they obtain a mortgage to help get the deal done. Besides the interest on the mortgage to obtain the rental property, there are other deductions allowed such as advertising, real estate taxes, management fees, auto expenses, insurance -- and the list goes on from there. The income and expenses are reported on Schedule E, Supplemental Income and Loss, and you will see that once it is calculated, the depreciation is deducted on Part 1 line 18 of the form.

I believe that once you go back and revisit your particular situation regarding the depreciation expense allowed on your rental property, you will find that Uncle Sam is being more fair to rental property owners than you originally thought.

Thank you for the great question and all the best to you.

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