Every business owner who owns or rents property needs to know how to depreciate renovation costs. Why?
For many of the clients I’ve worked with, depreciation is the difference between a profitable rental property business that succeeds and one that fails, so it’s definitely worth getting a handle on.
Allocate the cost of an asset over its useful life
Leaving aside rental property renovations for a moment, here’s how depreciation works, in general.
The Internal Revenue Service (IRS) allows you to allocate the cost of a physical asset over the course of its useful life. Depreciation refers to how much of that asset’s value has been used.
In the agency’s own words:
“Depreciation is an annual income tax deduction that allows you to recover the cost or other basis of certain property over the time you use the property. It is an allowance for the wear and tear, deterioration, or obsolescence of the property.”
How should you think about forecasting?
Think of depreciation as a more accurate way of accounting for the cost of an asset being used (instead of assuming the whole cost of renovation occurs at the point of purchase).
Depreciation reduces your taxes
As the value of an asset decreases due to depreciation, the amount of taxes you pay goes down via depreciation-related tax deductions.
How depreciating renovation costs can be tax-neutral
Let’s state the obvious before we move on: Properties must be maintained, or else they become unusable, right? That means you’re spending money just to continue operations (if your property is related to your business) or keep cash flow steady (if your business collects revenue from tenants).
Renovations must be done. So, how do we stay tax-neutral? We use depreciation to subtract the cost of renovations from your taxable income. Now that we have that concept nailed down, let’s move on to some examples of renovation that are tax deductible.
Renovate, acquire tenants, and save on the back end.
If your property is geared toward the residential market, you’ll want to renovate by:
- Painting walls or ceilings
- Installing new light fixtures
- Refinishing countertops or cabinets
- Updating windows and doors
I often see vacation rentals renovated to add more amenities and more comfort.
If you rent to a business tenant or are looking to attract a tenant, look for functional and aesthetic renovations that fit your acquisition strategy. A lot of restaurants and hip boutiques popping up? Renovate the space to match.
Regardless of the reason, one thing is true: Renovations are a significant investment in money and time for property owners.
Fortunately, depreciation offers an opportunity to mitigate the “bite” of such an investment.
The IRS has some rules for depreciating property
Here’s what the IRS has to say about what properties you can depreciate:
- It must be a property you own.
- It must be used in your business or income-producing activity.
- It must have a determinable useful life.
- It must be expected to last more than 1 year.¹
Also, be aware that you can’t depreciate the land a property is on because it doesn’t get “used up” the way a building does. That means you can’t depreciate the costs of clearing, planting, or landscaping.
Costs are depreciated over 27.5 years for residential properties
The IRS has a schedule for how long different property types are considered beneficial. For residential rental property, that period is 27.5 years. So, for each of those years, you can deduct a portion of the cost.
For commercial properties, that number is 39 years.¹
Cost segregation offers significant savings
There’s one depreciation method that property owners have a hard time understanding, but it’s critical if you want to know how to depreciate renovation costs effectively.
Cost segregation, also called cost segmentation, allows you to reclassify components of a building or property to shorter depreciation periods, usually 5, 7, or 15 years. Reclassification opens opportunities for a wider range of tax deductions.
Cost segregation is a four-step process.
Step #1: Start with an inspection
You’ll want to hire a qualified consultant for a cost segregation study. This study involves thoroughly inspecting your property, during which they identify the various building components.
Step #2: Categorize your assets
After the inspection, assets are categorized into groups based on their depreciable life.
For example, items like electrical systems might be classified as 5 or 7-year property, while the main building structure remains 27.5 or 39-year property.
Step #3: Create a schedule adjustment
Now, all that’s left is to create a new schedule for the components of your property that have been reclassified. Once you’ve created a new schedule, your property can be depreciated with the bulk of savings from deductions in the early years of ownership.
Step #4: Save big on taxes
The accelerated depreciation deductions generated through cost segregation reduce your taxable income and lower your tax liability.
Every cost segregation study will be different, but it’s fair to say that the process could give you annual tax savings somewhere between $10,000 to $50,000 or more.
This number will vary based on factors like the property’s characteristics, the quality of the cost segregation study, and the applicable tax rate.
So, you know how to depreciate renovation costs. Let’s start today.
I’m a Fort Worth-based CPA with more than a decade of experience helping businesses like yours to reduce their tax liability. If you’re interested in learning more about how depreciation fits into a large-scale tax plan, I can help.
Just schedule a discovery call to get started.
Jeremy A. Johnson, CPA
- Publication 946 (2022), how to depreciate property. Irs.gov. [cited 2023 Aug 23]. Available from: https://www.irs.gov/publications/p946