How to Calculate Rental Property Depreciation

Rental properties allow investors to gain passive income. However, like with any home, certain features of a rental property are going to break down and need maintenance over time. To help compensate for this expense, one of the deductions you can claim is rental property depreciation on income tax

Some real estate investors have a large net worth, have high levels of rental income, and pay little to no taxes. But how? The short answer, they’re able to maximize their tax deductions with depreciation on their assets. If you’re interested in strategically leveraging depreciation to lower your taxes and boost your cash flow, here’s everything you need to know about it—from the advantages it has to offer, to how to calculate it, and so much more.

Key Takeaways: 

• Rental property owners can use depreciation to deduct the property’s purchase price and improvement costs from their tax returns.
• Depreciation commences as soon as the property is placed in service or available to use as a rental.
• By convention, most of Nigeria’s rental property, as in other countries, is typically depreciated at a rate of 3.636% each year for 27.5 years.
• Only the value of buildings can be depreciated; you cannot depreciate the land buildings are built on.

Basics of Depreciation

Depreciation, in the context of real estate, refers to the gradual loss in value of a property over time due to wear, tear, and obsolescence. It’s a non-cash expense that allows property owners to account for the declining value of their asset over its useful life.

Depreciation in Real Estate

In real estate, depreciation is a crucial accounting concept that acknowledges the inevitable decline in the value of physical structures and improvements. While the land itself does not depreciate, buildings, fixtures, and other tangible assets associated with the property experience depreciation over time.

Types of Depreciation: Physical and Functional

Depreciation can be categorized into two main types: physical depreciation and functional depreciation. Physical depreciation refers to the wear and tear that occurs naturally as a property age. 

Functional depreciation, on the other hand, pertains to the loss in value due to functional inadequacies or obsolescence, such as outdated design features or inefficient layouts.

FIRS/LIRS Guidelines and Capital Allowances

The Federal Inland Revenue Service (FIRS) and the Lagos Inland Revenue Service (LIRS), along with other state inland revenue services, provide guidelines and schedules for capital allowances that dictate the allowable deductions for depreciation of rental properties and other assets used for business purposes.

Understanding these guidelines and adhering to the prescribed capital allowance rates and schedules is crucial for property owners and investors to accurately calculate depreciation expenses and maximize tax benefits.

The key points regarding capital allowances for rental properties in Nigeria are:

• Initial Allowance: Property owners may be eligible for an initial allowance, which is a one-time deduction of a specified percentage of the cost of the property in the year of acquisition.
• Annual Allowances: After the initial allowance, property owners can claim annual allowances, which are deductions based on a percentage of the remaining balance of the property’s cost. The applicable rates vary depending on the type of property and its classification (e.g., residential or commercial).
• Depreciation Schedules: The FIRS and state inland revenue services provide schedules that outline the applicable rates and periods for claiming capital allowances on different types of assets, including buildings, furniture, and equipment.
• Recapture Provisions: If a rental property is sold or disposed of, the owner may be required to recapture or reverse a portion of the previously claimed capital allowances, which would be subject to taxation.

How to Tell if An Asset Is Depreciable

When it comes to determining if a rental property asset is depreciable for tax purposes in Nigeria, here are the key factors to consider:

• Qualifying Capital Expenditure (QCE): The rental property or its components (e.g., buildings, fixtures, fittings) must qualify as a Qualifying Capital Expenditure (QCE) under Nigerian tax laws. QCEs generally include expenditures incurred on tangible assets used for generating income from a trade or business.
• Asset Classification: The rental property asset must fall into one of the categories specified in the tax laws and regulations, such as buildings, plant and machinery, furniture, and fittings. Different components may have different capital allowance rates and periods.
• Ownership and Use: The rental property asset must be owned and used by the taxpayer for generating rental income from a trade or business.
• Useful Life: The rental property asset must have a limited useful life, as capital allowances are intended to provide relief for the depreciation or wear and tear of assets over their useful lifespan.
• Qualifying Period: The rental property asset must have been acquired or brought into use during the relevant tax year or basis period for which capital allowances are being claimed.
• Non-Depreciable Assets: Land is generally not depreciable, as it is not subject to wear and tear.

To determine the specific capital allowance rates and schedules applicable to rental property assets, it is advisable to consult with a tax professional or refer to the relevant guidelines provided by the Federal Inland Revenue Service (FIRS) and the appropriate State Inland Revenue Service (IRS).

Calculating Rental Property Depreciation in Nigeria

In Nigeria, rental property depreciation, or capital allowances, is calculated based on the guidelines and rates provided by the Federal Inland Revenue Service (FIRS) and the relevant State Inland Revenue Service (IRS). Here’s an example of how rental property depreciation is typically calculated:

Assume you purchased a rental property in Lagos for ₦50,000,000, including the following components:

• Building: ₦40,000,000
• Furniture and Fittings: ₦5,000,000
• Plant and Machinery (e.g., generators, air conditioners): ₦5,000,000

Step 1

Determine the initial allowance

According to the recent FIRS guidelines released in february, 2024, you can claim an initial allowance of 15% on the qualifying expenditure for the building in the year of acquisition with the exemption of companies in the manufacturing and agricultural sectors.

Initial Allowance = 15% of ₦40,000,000 = ₦6,000,000

Step 2

Calculate the annual allowance for the building

After the initial allowance, you can claim an annual allowance of 10% on the remaining balance of the building cost for the following years.

Annual Allowance = 10% of (₦40,000,000 – ₦6,000,000) = ₦3,400,000 per year

Step 3

Calculate the annual allowance for furniture and fittings

For furniture and fittings, the current FIRS rate is 20% per year.

Annual Allowance = 20% of ₦5,000,000 = ₦1,000,000 per year

Step 4

Calculate the annual allowance for plant and machinery

For plant and machinery, the current FIRS rate is 25% per year.

Annual Allowance = 25% of ₦5,000,000 = ₦1,250,000 per year

Step 5

Calculate the total annual depreciation (capital allowance)

In the first year, the total depreciation (capital allowance) you can claim is the sum of the initial allowance and the annual allowances for each asset category:

Total Depreciation (Year 1) = ₦6,000,000 + ₦3,400,000 + ₦1,000,000 + ₦1,250,000 = ₦11,650,000

In subsequent years, the total depreciation (capital allowance) will be the sum of the annual allowances for each asset category.

Benefits of Rental Depreciation

Rental property depreciation offers several benefits that can significantly reduce taxable income and improve cash flow for property investors:

Tax Efficiency

Rental property depreciation is a powerful tax tool that allows landlords to deduct a portion of their property’s value each year. By reducing taxable income, landlords can lower their overall tax liability. 

Enhanced Cash Flow

Because depreciation allows you to offset taxable profits, it also enables you to increase your net rental income. This means more money stays in your pocket, and you have more cash on hand to cover expenses, make improvements, or allocate towards other investments. Essentially, it provides a tangible financial boost to a property’s profitability.

Capital For Reinvestment

The funds saved through depreciation can be reinvested back into the property. With the extra financial flexibility, you can acquire additional rental units or continually enhance the quality and value of other rental properties you may own.

Improved Return On Investment (ROI)

Maximizing depreciation will help you get the most out of your initial investment. By utilizing this tax benefit effectively, you can significantly increase your return on the property over time, making it a more financially rewarding venture.

Long-Term Wealth Building

Depreciation contributes to the building of equity over time. While the property may be depreciated for tax purposes, its market value may be appreciating. In turn, this dual effect can bolster long-term wealth and financial security through real estate investments.

Competitive Advantage

When your tax burden is lowered, you can set more competitive rental prices, which can attract a wider pool of potential tenants, increasing the property’s occupancy rate and overall profitability.

Risk Mitigation

Having extra funds available serves as a financial cushion for unforeseen expenses or economic downturns. It provides a safety net that can be crucial in times of unexpected challenges, ensuring that the property remains financially stable.

Limits and Considerations

Despite its tax advantages, rental property depreciation is subject to certain limits and considerations that investors should be aware of:

Capital Allowance Recapture and Balancing Adjustments

In Nigeria, when a rental property is sold or disposed of, there may be a requirement to recapture or reverse a portion of the previously claimed capital allowances (depreciation deductions). This process is known as making a balancing adjustment, and it is governed by the provisions of the Companies Income Tax Act (CITA) and the relevant guidelines from the Federal Inland Revenue Service (FIRS) and State Inland Revenue Services (IRS).

If the sale proceeds of the rental property exceed the tax written-down value (TWDV) of the asset, the excess amount is considered a balancing charge, which is taxable as income in the year of disposal. Conversely, if the sale proceeds are lower than the TWDV, the difference is treated as a balancing allowance, which is deductible from the taxpayer’s income.

Treatment of Capital Allowances and Capital Gains Tax

The claiming of capital allowances (depreciation) during the ownership period may impact the calculation of capital gains tax when the rental property is eventually sold or disposed of. In Nigeria, capital gains tax is generally payable on the chargeable gains derived from the disposal of qualifying capital assets, including rental properties.

The chargeable gain is typically calculated as the difference between the disposal proceeds and the adjusted cost base of the asset, which takes into account the capital allowances claimed over the ownership period.

Depreciation and Real Estate Investing

Understanding the implications of rental property depreciation is essential for real estate investors looking to optimize their investment strategies and maximize tax efficiency:

Importance of Depreciation in Cash Flow Analysis

Depreciation plays a crucial role in cash flow analysis for rental properties. By accurately accounting for depreciation expenses, investors can assess the property’s true profitability, evaluate potential returns, and make informed decisions regarding acquisition, financing, and property management.

Incorporating Depreciation into Investment Strategies

Successful real estate investors incorporate depreciation into their investment strategies to enhance cash flow, minimize tax liabilities, and improve overall returns. By leveraging depreciation deductions and tax benefits, investors can optimize their portfolio performance and achieve long-term financial objectives.

Long-Term Implications for Property Valuation and Portfolio Growth

Depreciation can also impact property valuation and portfolio growth over the long term. As depreciation deductions reduce taxable income and increase cash flow, investors can reinvest savings into additional properties, diversify their portfolios, and accelerate wealth accumulation through strategic asset allocation and growth-oriented investment strategies.

Conclusion

Depreciation can be valuable if you invest in rental properties because it allows you to spread out the cost of buying the property over decades, thereby reducing each year’s tax bill. Of course, if you depreciate property and sell it for more than its depreciated value, you’ll owe tax on that gain through the depreciation recapture tax.

Because rental property tax laws are complicated and change periodically, it’s always recommended that you work with a qualified tax accountant when establishing, operating, and selling your rental property business. That way, you can receive the most favorable tax treatment and avoid surprises at tax time.

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