Real estate depreciation is a method used to deduct market value loss and the costs of buying and improving a property over its useful life from your taxes. The IRS allows you to deduct a specific amount from your taxable income every full year you own and rent a property.
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 U.S. residential rental property 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.
What Is Rental Property Depreciation?
When you buy a property to use as a rental—an investment property—you'll inherit all the costs of maintaining, improving, and managing it. Owning and renting property is considered a business endeavor because you're generating income from it. You'll also have to include any income you generate in your taxes.
The property is an asset that helps you generate income, similar to a manufacturer and the equipment or machines they buy to produce their product. Over years of use, the value of these manufacturing machines—or your rental property—declines, which is called depreciation. So, the IRS gives you a break by assuming that your investment property will lose value over time as you rent and maintain it. It allows you to deduct those costs and loss of value by spreading it out over a period of years.
Property and large equipment also experience economic depreciation. Economic depreciation is a decrease in the value of the asset due to negative influences, such as an across-the-board drop in real estate prices.
How Rental Property Depreciation Works
There are several factors you need to consider when you're depreciating rental property. You'll have to know which system to use, whether the property is depreciable, when to start depreciating it, and what the tax consequences are.
Depreciable Property
According to the IRS, you can depreciate a rental property if it meets all of these requirements:
- You own the property (you are considered to be the owner even if the property is subject to a debt).
- You use the property in your business or as an income-producing activity.
- The property has a determinable useful life, meaning it wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes.
- The property is expected to last for more than one year.
Even if the property meets the above requirements, it cannot be depreciated if you placed it in service and dispose of it (or no longer use it for business use) in the same year.
Note that land isn't considered depreciable since it never gets "used up." In general, you cannot depreciate the costs of clearing, planting, and landscaping, as those activities are considered part of the cost of the land and not the buildings.
Starting Depreciation
You can begin taking depreciation deductions as soon as you place the property in service or when it's ready and available to use as a rental.
Here's an example: You buy a rental property on May 15. After working on the house for several months, you have it ready to rent on July 15, so you begin advertising online and in the local papers. You find a tenant, and the lease begins on Sept. 1. As the property was placed in service—that is, ready to be leased and occupied—on July 15, you would start to depreciate the house in July and not in September when you start to collect rent.
You can continue to depreciate the property until you have deducted your entire cost or other basis in the property or you retire it from service. This applies even if you have not fully recovered its cost or other basis. A property is retired from service when you no longer use it as an income-producing property—or if you sell or exchange it, convert it to personal use, abandon it, or if it's destroyed.
You can continue to claim a depreciation deduction for property that's temporarily "idle" or not in use. If you make repairs after one tenant moves out, you can continue to depreciate the property while you get it ready for the next.
Depreciation Systems
Any residential rental property placed in service after 1986 is depreciated using the Modified Accelerated Cost Recovery System (MACRS). This accounting technique spreads costs (and depreciation deductions) over 27.5 or 30 years, depending on the method used. This is the amount of time the IRS considers to be the “useful life” of a rental property.
Two methods are used to determine depreciation—the General Depreciation System (GDS) or the Alternative Depreciation System (ADS). GDS applies to most properties placed in service, and in general, you must use it unless you make an irrevocable election for ADS or the law requires you to utilize ADS.
ADS is mandated when the property:
- Nonresidential real property, residential real property
- Any property with a recovery period of 10 years or more under GDS held by an electing farming business
- and qualified improvement property held by an electing real property trade or business
- Has a qualified business use 50% of the time or less
- Has a tax-exempt use
- Is financed by tax-exempt bonds
- Is used primarily in farming
In general, you'll use GDS unless you have a reason to employ ADS.
Tax Concerns
Investing in rental property can prove to be a smart financial move. For starters, a rental property can provide a steady source of income while you build equity in the property as it (ideally) appreciates over time. There are also several tax benefits. You can often deduct your rental expenses from any rental income you earn, thereby lowering your overall tax liability.
Most rental property expenses, including mortgage insurance, property taxes, repair and maintenance expenses, home office expenses, insurance, professional services, and travel expenses related to management are all deductible in the year you spend the money.
Another key tax deduction—namely, the allowance for depreciation—works somewhat differently. Depreciation is the process used to deduct the costs of buying and improving a rental property. Rather than taking one large deduction in the year you buy (or improve) the property, depreciation distributes the deduction across the useful life of the property.
If you rent real estate, you typically report your rental income and expenses for each rental property on the appropriate line of Schedule E when you file your annual tax return. The net gain or loss then goes on your 1040 form. Depreciation is one of the expenses you’ll include on Schedule E, so the depreciation amount effectively reduces your tax liability for the year.
If you depreciate $3,599.64 and are in the 22% tax bracket, you’ll save $791.92 ($3,599.64 x 0.22) in taxes that year because it is deducted from your income.
Calculating Rental Property Depreciation
Once you know which MACRS system applies, you can determine the recovery period for the property. The recovery period using GDS is 27.5 years for residential rental property. If you're using ADS, the recovery period for the same type of property is 30 years if it was placed in service after Dec. 31, 2017, or 40 years if placed in service before that.
Next, determine the amount that you can depreciate each year. Most residential rental property uses GDS, so we'll focus on that calculation.
For every full year a property is in service, you would depreciate an equal amount: 3.636% each year as long as you continue to depreciate the property. If the property were in service for less than one year, you would depreciate a smaller percentage that year, depending on when it was put in service. According to the IRS Residential Rental PropertyGDS table, if the property was put into service in the month of:
- January: Use 3.485%
- February: Use 3.182%
- March: Use 2.879%
- April: Use 2.576%
- May: Use 2.273%
- June: Use 1.970%
- July: Use 1.667%
- August: Use 1.364%
- September: Use 1.061%
- October: Use 0.758%
- November: Use 0.455%
- December: Use 0.152%
Every year after the first year you placed it service, you would use 3.636%.
For example, your rental house has an adjusted basis of $99,000. You put into service on July 15, so:
- You'll depreciate 1.667% for the first year, or $1,650.33 ($99,000 x 1.667%).
- Every year after that, you'll depreciate at a rate of 3.636%, or $3,599.64
- You can continue to depreciate it as long as the rental is in service for the entire year.
Note that this figure is essentially equivalent to taking the basis and dividing by the 27.5 recovery period: $99,000 ÷ 27.5 = $3,600. The small difference stems from the first year of partial service.
Special Considerations
Several factors determine the amount of depreciation you can deduct each year. If you're unfamiliar with what you can include in your depreciation calculation, you should have an accountant help you. The IRS doesn't allow you to use the amount you paid for the building and property as the basis—you'll need to separate the basis of the building and the property.
Determining Basis
The basis of the property is the amount you paid (in cash, with a mortgage, or in some other manner) to acquire the property. Some settlement fees and closing costs, legal fees, recording fees, surveys, transfer taxes, title insurance, and any amount you agreed to pay (such as back taxes) when you purchased the property are included in the basis.
Some settlement fees and closing costs can't be included in your basis. These include fire insurance premiums, rent for tenancy of the property before closing, and charges connected to getting or refinancing a loan, including points, mortgage insurance premiums, credit report costs, and appraisal fees.
So, imagine you purchased a home for a total of $255,375. To determine your basis, you'll likely need to use the latest real estate tax assessment, which generally divides the property into land and building tax value. Typically, you can get this information from your county's tax office.
If you found your basis in the house was 85% of the total value, your basis would be $217,068.75 (85% of $255,375). The land's basis would be $38,306.25. Then, you need to figure out your adjusted basis to use for your depreciation calculation.
Determining Adjusted Basis
You may have to increase or decrease your basis for certain events that happen between the time you buy the property and the time you have it ready for rental. Examples of increases to basis include the cost of any additions or improvements that have a useful life of at least one year made before you place the property in service, money spent to restore damaged property, the cost of bringing utility services to the property, and certain legal fees.
Decreases to the basis can be from insurance payments you receive due to damage or theft, casualty loss not covered by insurance for which you took a deduction, and money you receive to grant an easem*nt.
How Much Can You Depreciate a Rental Property?
Generally, U.S. rental properties are depreciated at a rate of 3.636% over 27.5 years.
Can Rental Depreciation Offset Ordinary Income?
Yes, but it's best to consult a tax professional to make sure it's in your best interest to do so.
How Do You Avoid Depreciation on a Rental Property?
You can sell it for a loss or turn it into your primary residence if you've owned it for five years and have lived in it for two of those years.
The Bottom Line
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.
