Rental property depreciation is something every property owner will have to deal with at some point. Learn more about rental property depreciation and what it means to you in terms of tax savings and expenses in this complete guide to rental property depreciation.
1. What is Depreciation in Rental Property?
Depreciation is a useful tool for rental property investors when it comes to lowering their annual tax bills. It allows them to deduct the cost of their property, along with improvement expenses annually and over a long period.
In fact, this period is actually 27.5 years for residential real estate and 39 years for commercial real estate. This is known as the recovery period and it’s the length of time depreciation value can be claimed on your taxes.
The basic premise of depreciation is that through usage, wear and tear, or obsolescence, a tangible asset, like property, loses value over time. This loss can be calculated and claimed on a tax return as a deduction over the recovery period until the property is sold or your entire cost basis is recovered, which is the amount your property is worth.
A property owner can claim depreciation as long as they own the property and generate income from it. That means that if you use the property as part of your business or as a source of income and the property not only has a useful life but that life is expected to last more than a year.
Depreciation functions as a way of getting a benefit from an expense without writing a check. It allows you to take deductions on the perceived decrease in value of your property over time.
Depreciation also allows the property owner to spread out a deduction over several years, rather than claiming the total amount all at once and, as a result, getting hit with a higher tax bill the very next year.
Thankfully, beyond depreciation, there are more deductions you can claim to lower your annual tax bill, and expense management makes claiming those deductions a lot easier.
2. How to Depreciate a Rental Property?
Depreciation begins immediately after a property becomes available for rent or goes into commercial use. If you begin renting out your property during a calendar year that’s already begun, the amount of depreciation available to you is prorated in that first year.
Below you’ll find out how much depreciation you can claim, depending on the month that the property is available for rental according to the IRS Publication 527, which pertains to residential rental properties.
*Current as of December 2021
Once a property is in service for business use or income generation for more than one year, you would depreciate it an equal amount at 3.636% for each year it’s rented up to 27.5 years.
Keep in mind, only the value of the building or home can be depreciated, not the value of the land it sits on.
There are two systems under the Modified Accelerated Cost Recovery System (MACRS) used by the IRS to calculate depreciation and you must determine which system your property falls under before you can go on to calculate its depreciation cost.
The General Depreciation System
The GDS is the depreciation system that most owners use when calculating depreciation. It applies to the majority of properties other than properties that must use the Alternative Depreciation System (ADS) by law or if an owner elects to use the ADS and that choice is irreversible. Under the GDS, a residential property can depreciate for the standard 27.5 years.
The Alternative Depreciation System
The Alternative Depreciation System is used under the following circumstances:
- The building has a qualifying business used 50% of the time or less
- The building is used mostly for farming
- The building is financed by tax-exempt bonds
- The building is used for an income-generating endeavor that itself is tax-exempt
The system used affects the length of the depreciation recovery period. Under the ADS, the recovery period is 30 years if the property is generating income after Dec. 31, 2017, and 40 years if the property started generating income before that.
3. How to Calculate Depreciation on Rental Property?
Calculating depreciation under the Modified Accelerated Cost Recovery System of the IRS is relatively easy and straightforward.
All you need to do is follow these steps:
1. Determine the cost basis of the property
The cost basis of your property is how much you paid for the property plus closing costs and the cost of any improvements you’ve made to the property (i.e., a pool, a gym, a deck, etc.) minus the value of the land it sits on.
For example, if you paid $1 million for a property, your closing costs were $20,000 and let’s say you added a $4,000 deck to the property, but the land costs $60,000, your cost basis equation would look like this:
1,000,000 + 10,000 + 4,000 + 20,000 – 60,000 =
So the cost basis of your property would be $974,000
If you’re wondering what costs may constitute closing costs and/or settlement fees that may go into your cost basis calculation, the list can include the following:
- Abstract fees
- Legal fees
- Recording fees
- Transfer taxes
- Title insurance
- Utility installation fees
- Any amount the seller of the property owes that you agree to pay such as back taxes, interest, recording or mortgage fees, charges for improvements or repairs and sales commissions.
There are also closing costs and settlement fees you can’t include as part of your basis cost calculation and these are the following:
- Fire insurance
- Rent or other charges related to the property’s occupancy before closing.
- Any charges related to getting or refinancing a loan such as points, (discount points and loan origination fees) mortgage insurance premiums, loan assumption fees, cost of a credit report and fees for an appraisal required by a lender.
2. Calculate the Property’s Depreciation Cost
To calculate the depreciation cost of a property, divide the basis cost by the recovery period, which is 27.5 years for residential income properties.
This is known as the straight-line method for calculating depreciation cost and it’s the only acceptable formula for calculating the depreciation cost of a property according to the IRS.
Alternatively, the IRS makes it even easier by telling you the percentage of depreciation expense you can claim each year, so just multiply your basis cost by 3.636%, which is the annual depreciation percentage for income properties. This will let you get your depreciation cost each year.
So, if your property is worth $1,000,000, multiply that by 3.636% to get your depreciation cost of $36,360, which you can then claim as a deduction on your tax return.
In the first year, if your property didn’t start generating income right from the first day of the year to the last, just pick the percentage from the month when it did go into service from the table in the “How to Depreciate a Rental Property” section of this article and multiply the basis cost by that percentage instead in year one.
4. How to Avoid Depreciation Recapture Tax on Rental Property?
You may be able to claim your investment property’s annual depreciation cost as a yearly deduction. However, when you sell that same property, the IRS will try to collect or recapture that amount through a recapture tax, which is the difference between the sale value and the depreciated value of the property.
Your depreciation recapture tax is capped at 25% of your original depreciated value, depending on your usual income tax rate when you profit from the sale of the property.
After recapture tax is taken by the IRS, capital gains tax is applied to the remainder of your profit. Learn more about capital gains tax in the Tax Guide for Buying and Selling Real Estate.
The good news is, you can avoid recapture tax in the same way that you can avoid capital gains tax and that’s by deferring both of them through a 1031 Exchange.
A 1031 Exchange is named after the section of the American Tax Code where this exchange is discussed and it allows you to defer paying both capital gains and recapture tax as long as you are buying another rental property with the proceeds that you gain from the sale of your current property.
As long as you are continuing your rental business and buying what the IRS calls a property that’s “like-kind” to your previous one, you will not have to pay both capital gains and recapture tax until you sell the property you just acquired. However, it’s important to note that you have 45 days after closing to identify up to three replacement income properties. If you don’t identify a replacement property within 45 days, you will not be able to pull off a 1031 Exchange.
Final Thoughts on Depreciation: Short-Term Gain, Long-Term Pain
Your depreciation cost will lower your tax bill every year, saving you money. However, that deduction could end up putting a dent in your profits from the sale of the same property it initially saved you money on, thanks to Depreciation Recapture Tax.
Make sure your landlord banking is on point and carefully consider whether you really want to deduct depreciation to save money in the short-term only to end up paying recapture tax when you sell.
Understand the risk of recapture tax and how buying another rental or investment property may help you avoid it temporarily.
Besides depreciation cost, rental property owners may be able to deduct mortgage interest, property taxes, operating expenses, and repairs.
To quote the IRS, “You can deduct the ordinary and necessary expenses for managing, conserving, and maintaining your rental property. Ordinary expenses are those that are common and generally accepted in the business. Necessary expenses are those that are deemed appropriate, such as interest, taxes, advertising, maintenance, utilities, and insurance. You can also deduct the costs of certain materials, supplies, repairs, and maintenance that you make to your rental property to keep your property in good operating condition.”
You can also deduct expenses the tenant paid if they are actually deductible rental expenses. When you factor in the fair market value of your rental property, you can deduct that cost as a rental expense.
Make sure you keep a record of how much you paid for the property including closing costs like property taxes, lawyer fees, and more.
These records will be used to calculate the cost basis of the property. You should also keep track of the residual value of the property if there happens to be any.
Also, look up the IRS’s chart for the depreciation percentage for every month in the first year so that you can still calculate depreciation even if you didn’t start renting the property from the beginning to the end of that year.
Remember that you must be able to substantiate certain elements of expenses to deduct them and generally must have evidence like receipts or bills, to support your deduction claims on expenses.
You must choose to itemize your tax deductions to claim your income property expenses. You have to file IRS Schedule E Form 1040, for up to three properties you own to claim expenses on each one.
Since IRS Form 1040, Schedule E can only fit three properties on a single form. You need additional copies of the same form for additional properties you may own.