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 (typically 3.636%) from your taxable income every full year you own and rent a property.
- 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—depreciates. 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 can 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 or not, when you start depreciating it, and what the tax consequences are.
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." And 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.
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 to advertise 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 one of the following conditions until you have deducted your entire cost or other basis in the property or you retire the property 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.
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:
- 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.
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.
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.
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 $255375). 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 make increases or decreases to 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 easement.
Do You Have To Pay Back Depreciation on Rental Property?
If you've calculated depreciation correctly, you shouldn't have to pay it back. But if you've made a mistake, the IRS may ask you to repay it.
What IRS Form Is for Depreciation of Rental Property?
You file Form 4562 for depreciation, where Part III, MACRS Depreciation, accounts for your rental property depreciation.
How Does Depreciation Work When You Sell a Rental Property?
If you sell your rental property for more than your purchase price, you might be subject to depreciation recapture, which is income tax on the gain at your normal income tax rate.
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.
You can depreciate the value of your property, not its land, by dividing your building value (depreciable basis) by the property's useful life value. To do this, you must subtract the land value from the building value, then divide the building value by 27.5.What is the formula for depreciation? ›
To calculate depreciation using the straight-line method, subtract the asset's salvage value (what you expect it to be worth at the end of its useful life) from its cost. The result is the depreciable basis or the amount that can be depreciated. Divide this amount by the number of years in the asset's useful lifespan.What happens after 27.5 years of depreciation? ›
After 27.5 years, the entire cost basis has been deducted, and depreciation ends. Depreciation can also stop after the property is sold or the rental property has stopped producing income.What is the depreciation rate for rental property? ›
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 are the 3 methods to calculate depreciation? ›
The four methods for calculating depreciation allowable under GAAP include straight-line, declining balance, sum-of-the-years' digits, and units of production.What is the 6 month rule for depreciation? ›
The half-year convention calculates six months of depreciation during an asset's first and last year of service. For more information about depreciation conventions, see Depreciation methods and conventions.How many years is 20% depreciation? ›
For example, in a 12 period year, if an asset's expected life is 60 months, the annual depreciation rate for the asset is: 12/60 = 20%, and the depreciation rate per period is 20% /12 = 0.0167%.How much can I depreciate per year? ›
Residential buildings, if constructed after September 1987, have an Effective Life of 40 years. Buildings depreciate at 2.5% every year for 40 years – 2.5% x 40 years = 100%.Can I depreciate my rental property UK? ›
Answer. No Depreciation will be charged on the investment property. As per the FRS 102, section 16.7, An investment property shall be measured at fair value at each reporting date with changes in fair value recognized in profit or loss.What is the formula for depreciation GCSE? ›
In order to calculate a depreciation: Subtract the depreciation rate from 100 100%. Convert this percentage into a decimal to find the multiplier. Multiply the initial value by the multiplier raised to the power of the number of years (or given time period).
The SYD function calculates the sum-of-years' digits depreciation and adds a fourth required argument, per. The syntax is =SYD(cost, salvage, life, per) with per defined as the period to calculate the depreciation. The unit used for the period must be the same as the unit used for the life; e.g., years, months, etc.