How to Calculate Depreciation on a Rental Property

Depreciation refers to the gradual decrease in the value of an asset over time.

In terms of rental properties, this involves accounting for the wear and tear on the building and any included furnishings over the years.

Depreciation plays a crucial role in your rental property tax deductions.

It allows you to recover the costs associated with income-producing properties through your yearly tax returns. Savvy investors understand that factoring in depreciation can significantly impact their investment returns.

There are different methods for calculating depreciation, but for residential rental properties, the most commonly used is the Modified Accelerated Cost Recovery System (MACRS).

The MACRS is the standard tax depreciation system in the United States.

Under MACRS, residential rental properties are depreciated over a 27.5-year lifespan.

Determine Your Cost Basis

The cost basis of your rental property is usually the amount you paid for the property, plus any substantial improvements. This doesn't include costs for repairs or maintenance.

Apply the Depreciation Rate

Divide the cost basis by 27.5 to find your annual depreciation expense. This represents the amount you can deduct from your taxable income every year for 27.5 years.

Imagine you bought a rental property for $275,000.

Your annual depreciation expense would be $275,000 divided by 27.5, which equates to $10,000 per year.

If you've made substantial improvements, like a new roof or HVAC system, add the cost of these to the property's cost basis and depreciate them separately.

Land and Property Value

When you buy a property, part of your cost basis is for the land, which doesn't depreciate. You must separate the land and building value when calculating depreciation.

The Half-Year Convention

The IRS applies the half-year convention, meaning you only claim half of the annual depreciation expense for the first and last year of property ownership.

When you sell a rental property,you may need to recapture the depreciation you claimed, which can impact your capital gains tax.

Depreciation is a fundamental accounting principle understood as the loss in value of an asset over a certain period.

In real estate, depreciation is an annual tax deduction possible because it is generally accepted that properties wear out over time, becoming less valuable.

The logic behind this is simple: over time, things break down.

A building's structure, systems, and equipment age, and consequently, their functionality and value decrease. In response, the Internal Revenue Service (IRS) allows investors to recoup their capital investments in a property gradually over the useful life of the property.

Depreciation is crucial for rental property owners.

It helps reduce taxable income, thereby saving money at tax time. By leveraging this, real estate investors can improve their investment's profitability.

Many investors overlook depreciation, thinking it's too complicated or that it doesn't make a significant difference.

This oversight could be costly. Depreciation is one of the major benefits of real estate investing, and taking advantage of it could mean the difference between a profitable and a non-profitable investment.

While the MACRS is the most popular method, other methods include the straight-line method and the declining balance method.

Each method has its specific applications and benefits, so it's essential to understand them to select the most appropriate for your situation.

The straight-line method is the simplest, dividing the property's cost basis evenly over its useful life.

The declining balance method, meanwhile, accelerates depreciation, allowing for larger deductions in the early years of property ownership.

Renovations and improvements, if they extend the property's useful life, can also be depreciated.

However, you must depreciate these costs separately over their individual recovery periods.

Major improvements might include upgrading wiring or plumbing, installing a security system, or replacing a roof or HVAC system.

The cost of these improvements is added to the property's cost basis and depreciated over their respective recovery periods.

When you sell a property for more than its depreciated value, you're liable for depreciation recapture.

It's a way for the IRS to collect taxes on the gain from selling the property, beyond just capital gains tax.

When it comes to depreciation recapture, you could be taxed at a rate up to 25% on the gain from the sale of the property, that is attributable to the depreciation deductions taken in prior years.

1. What is rental property depreciation?

Rental property depreciation is a tax deduction that allows real estate investors to recover the costs of income-producing properties.

2. How do I calculate depreciation on my rental property?

You calculate depreciation by determining your cost basis (usually the amount paid for the property plus substantial improvements), then dividing this by 27.5 to get your annual depreciation expense.

3. Can land value be depreciated?

No, only the value of the building itself can be depreciated, not the land it sits on.

4. What is the half-year convention?

The half-year convention allows you to claim half of the annual depreciation expense in the first and last year of property ownership.

5. What is depreciation recapture?

Depreciation recapture is the IRS rule that when a rental property is sold, the owner may have to pay taxes on the depreciation they claimed.

6. Can I ignore depreciation if I plan never to sell my property?

Even if you don't intend to sell, depreciation is crucial for your annual tax deductions. It lowers your taxable income, saving you money each year.

7. Is it necessary to consult a tax advisor?

While it's possible to calculate depreciation yourself, a tax advisor can help ensure accuracy and compliance with all applicable tax laws and regulations. They can also guide you on other tax benefits related to real estate investing.

8. What happens if I sell my property for less than its depreciated value?

If you sell your property for less than its depreciated value, you won't owe any depreciation recapture tax. You may even be able to claim a capital loss.

9. Can I choose the depreciation method I prefer?

While different depreciation methods exist, the IRS requires residential real estate investors to use the MACRS method.

10. Can I claim depreciation on my property right away?

You can start to depreciate your property as soon as it's ready and available for rent, not necessarily when you start renting it.