What is rental property depreciation and how does it work?

Real estate depreciation is the gradual reduction in a property’s value. Investors usually calculate it to deduct it from their taxable income. That way, they can lower their tax bill and maximize their profits.

Read on to learn more about this tax benefit for real estate investors.

What is rental property depreciation?

Rental property depreciation is a basic accounting principle that allows you to deduct the cost of a rental property over a set period of time. The Internal Revenue Service (IRS) assumes a rental property will lose a certain amount of value every year (typically about 3.6%).

For as long as you own the property, this loss (known as depreciation) can be subtracted from your taxable income every year (aka depreciating a rental property). This, in turn, can lower your taxes and may even drop you into a lower tax bracket.

How does rental property depreciation work?

When you buy rental property to add to your financial portfolio, you can expect to pay out a large sum of money to purchase the real estate. In return for your initial outlay of cash, the IRS has tax rules in place that offset the cost of the property by factoring in the assumed drop in the property’s value over time. However, the IRS won’t allow you to take the tax deduction all at once.

If you own a rental property, the federal government allows you to claim the depreciation of the property every year for 27.5 years. If you use the property for business or farming for more than 1 year, you can deduct the depreciation on your tax return over a longer period.

What is depreciation?

Here’s the central concept of depreciation: Most tangible assets (valuable material property) are depleted through usage or decay over their lifespan. The wear and tear reduces the value of the asset as time passes. It’s assumed that the asset, such as a piece of real estate, won’t remain in pristine condition.

What is the depreciation recovery period?

The recovery period, which is the time frame when depreciation can be claimed, is different for real estate assets versus other types of assets. While less expensive items such as office equipment and furniture have a recovery period of 7 years, residential buildings are depreciable over 27.5 years, and commercial properties have a 39-year recovery period.

How do you calculate annual depreciation?

To determine your annual depreciation amount, you must divide the cost basis and value of your property by its recovery period. Note that only the structure or building is depreciable – not the land the building sits on. Only buildings have a useful lifespan, and land never loses value to depreciation.

You can continue to claim depreciation during the recovery period until the property is sold to another party or your total cost basis has been fully depreciated.

Note that when service begins in a calendar year that has already started, the amount of depreciation available to you is prorated for the first-year term. Read through the monthly residential rental property percentages from the IRS Publication 527 table:

Who is eligible to claim real estate depreciation?

To claim depreciation on your rental properties:

• You must own the property (either outright or as you pay off debt, such as a mortgage).
• You must use the property in your business or as part of an income-producing activity.
• Your property must have a determinable useful life. In other words, the property’s value will decline or deplete over time.
• The property is expected to have a useful life that exceeds at least 1 year.

How to calculate rental property depreciation

As you look to offset taxable income, read on to see how rental property depreciation works and how to calculate it.

Step 1: Determine your cost basis for the building

Note that a rental property’s cost basis is not the same as its purchase price.

At purchase

The cost basis is the total capital expense of the property minus the value of the land it sits on. Only certain items qualify as capital expenses when calculating this sum, like legal, abstract, or recording fees, as well as any seller debts a buyer agrees to pay.

As improvements are made

Also be aware that the costs of any improvements to the property are added in the year they are incurred to determine the adjusted cost basis. Meanwhile, certain credits like insurance payments and energy subsidies are subtracted from your cost basis.

Such ongoing cost basis adjustments must be made to your original purchase cost basis, regardless of whether the impact on your taxable income is positive or negative.

Step 2: Calculate the amount of annual depreciation

The Modified Accelerated Cost Recovery System (MACRS) is the accounting system used for all residential buildings put into service after 1986. These properties use the General Depreciation System (GDS) outlined under its terms to calculate annual depreciation amounts.

For properties put into service before 1987, you can calculate depreciation by using the Accelerated Cost Recovery System (ACRS). If you need to use this system, consult accountants familiar with this depreciation method.

General Depreciation System (GDS)

Under the MACRS framework, most taxpayers will use the GDS. According to its rules, the recovery period for residential rental properties is 27.5 years, and the recovery period for commercial rental properties is 39 years. Because the GDS applies straight-line depreciation to both residential and commercial rental properties, you can divide the value of your property by its recovery period to calculate annual depreciation amounts.

Alternative Depreciation System (ADS)

Taxpayers must use the ADS method of depreciation if the property:

• Is used for a qualified business purpose only 50% or less in a year
• Has a tax-exempt use
• Is financed by tax-exempt bonds
• Is used primarily for agricultural or farming purposes         

Rental property owners who believe they must use ADS should consult an accountant to determine the best way to depreciate their property. Note that the 2017 Tax Cuts and Jobs Act shortened the recovery period for taxpayers using ADS from 40 years to 30 years.

Deductions vs. depreciation

Deductions are paid expenses that can be deducted from your income taxes in the same year they’re incurred. Depreciation, however, functions as a form of non-cash deduction. The total amount is amortized over the asset’s given recovery period and can reduce an investor’s taxable income by a maximum set amount in a year.

For example, replacement light bulbs that you buy for your rental property are an expense. New light fixtures you install will add to the value of the property and can be depreciated over time.

Depreciation is a way to receive the benefits of incurring an expense without actually paying any more money out of pocket or writing a check. Depreciation essentially lets you take tax deductions on the perceived decrease in value of your real estate holdings over time.

What is an operating expense vs. a capital expense?

An operating expense is a cost required as part of day-to-day business, while a capital expense is a cost you incur to create future benefits. This distinction is important because capital expenses can be added to your depreciation cost basis, increasing your tax write-off, but operating expenses cannot.

To qualify as a capital expense, an item purchased for your rental property must have a life expectancy of more than 1 year.

Rental property depreciation FAQ

Here are answers to some frequently asked questions:

When can I start taking depreciation?

Depreciation begins immediately after a property becomes available for rent or is put into commercial use. For example, say Taylor purchases a rental property on March 1 but doesn’t begin renting it out until March 15. Taylor can begin depreciating the property on March 15.

How long does depreciation last?

The recovery period, which is the period when residential rental property owners can write off depreciation, lasts until the cost basis (including any adjustments) has been depleted. Real estate investors who continue to improve their properties can continually adjust their cost basis as they go.

Is there a way to defer capital gains after claiming depreciation?

If you want to reinvest the proceeds into a new investment property, the IRS allows you to defer taxes on capital gains through a 1031 exchange. If the 1031 exchange is executed incorrectly, you could face depreciation recapture and a hefty tax bill.

What IRS forms do I file in order to claim depreciation?

To claim rental property depreciation, you’ll file IRS Form 4562 to get your deduction. Review the instructions for Form 4562 if you’re filing your tax return on your own, or consult a qualified financial advisor or tax accountant for assistance.

What if I buy new appliances for my rental properties? How would I deduct those expenses?

New appliances would not qualify as expenses because they have an expected useful life of 5 years. You can either depreciate the cost of the appliances over 5 years or add the cost of the appliances to the property’s cost basis and continue to depreciate against the new adjusted cost basis.

The bottom line: Property depreciation is a type of tax benefit

Ultimately, rental property depreciation is a valuable tax benefit that lets you gradually deduct the cost of a property from your taxable income, potentially lowering your overall tax bill. Keep in mind that only the building itself can be depreciated, not the land, and your cost basis must be adjusted over time as you make improvements.

If you’re ready to invest in rental property and start taking advantage of these tax benefits, completing the Rocket Mortgage application can help you explore your financing options. Start today!

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