What is Rental Property Depreciation & How to Calculate It (2024)

Maximize your profits with rental property depreciation.

As a real estate investor, rental property depreciation is one of those terms you know you should understand but put off learning about. Maybe you tucked it away in the back of your mind as a tax strategy you’ll address at another time. (You swear, you’ll figure out property depreciation another day.)

As it turns out, depreciation is probably a much simpler concept than you thought. But before we dive in, let’s clarify something: The best expert for your unique situation will be a local tax professional. Local or state regulations and rental property tax laws may complicate matters; at the very least, you want to be certain you’re doing everything correctly.

But here’s what you need to know to understand rental property depreciation if you’re a real estate investor.

What Is Rental Property Depreciation?

When you buy an investment property, through use, wear and tear, weathering, and so on, it degrades—or depreciates. Your car, for example, loses its luster over time. You don’t value a 2008 Camry the same way you value a 2020 model; the same goes for real estate.

This all sounds like a bummer, but there’s an upside: Depreciation offers real estate tax benefits for that degradation. These can be big boons for real estate investors willing to create a smart tax strategy. When you claim property depreciation, you can spread the deduction over the useful life of the income-producing property, rather than taking it all at once.

How It Works

Rental property owners are probably well aware of the deductions they can take from their taxable income. Such tax deductions include property taxes, mortgage interest, repairs, operating expenses, and depreciation.

Think of rental property depreciation as the deduction of part of the cost of the rental property over many years. Each year, you deduct a part of the cost until your cost is fully recovered. This time frame is known as the recovery period.

In many cases, rental property depreciation can greatly reduce your tax liability, or even eliminate it.

What Rental Property Can Be Depreciated?

Rental property owners find that most of their properties are depreciable because the primary rule for depreciation requires the property to be an investment or business—not your primary residence. You’ll need to rent to a tenant, whether residential or commercial.

Here are the other rules:

• You must own the property for at least one year.
• The property must endure wear and tear.
• You must actually own the property, meaning you’re not renting it from another investor.
• It must have a determinable useful life.

By these standards, pretty much all real estate investments should fit, especially residential rental properties.

Depreciating Improvements in a Rental Property

You’ll need to make improvements to your properties if you want to keep them profitable and raise their value. These improvements can be expensive, but according to the Internal Revenue Service, you can use real estate depreciation to offset the costs of making repairs.

If you make an improvement that adds value to your rental property, such as a major renovation or roof replacement, that is considered a capital expense. Therefore, you can’t claim the entire cost as tax deductions that year. But you can depreciate a capital expense over time.It’s important to keep records of the improvements you make. The Internal Revenue Service classifies improvements as anything that makes a property better than it previously was. This means things like restoring it if it was damaged in a natural disaster, expanding it by adding a room, or changing something so that it alters the way the building is used are all considered improvements that will have to be depreciated rather than deducted. Doing this right can mean big tax savings.

When Does Depreciation Begin and End?

Keep in mind exactly when you can begin rental property depreciation. Start depreciating your residential rental property when it is ready for rental—not when it is rented. If you buy rental real estate and are ready to rent it on day one, but it doesn’t end up renting for two weeks, you can start depreciating it from the time it was ready to rent. You’ll stop the rental property depreciation when you no longer own it, when you’ve recovered your basis, or the money you’ve put into buying and maintaining the property.

Consider these details about some situations where depreciation begins and ends:

Placed in service

Let’s say you had your rental property ready to go on May 15 but didn’t find a tenant until August 30. May 15 is when you can start to claim depreciation on the rental property, even though no one moved in until the end of August.

If you decide to replace the roof of the rental in September 2022 but work doesn’t begin on the project until November 2022, and bad weather delays the completion until February 2023, you can’t start depreciating the cost of the new roof until 2023. Depreciation begins on the day the item is placed in service and ready to be used as intended.

Idle property

An idle property can still be depreciated even when not in use. This means you can continue to depreciate your residential rental property while you’re getting it ready for a new tenant or waiting to rent it again after someone moves out.

Cost basis fully recovered

Once you’ve recovered your money from buying the property or maintaining it, you must stop depreciating the asset. You can only claim depreciation until your cost basis is fully recovered. Even if you didn’t use the depreciation claim, you can’t make the claim beyond full recovery of the original cost of the rental property.

Retired from service

If the rental property is retired from service, you can no longer claim depreciation for it. When you abandon the property or decide to convert it to personal use, it no longer qualifies as an income-producing activity, and you can’t claim depreciation any longer. Additionally, if the property is destroyed or you sell or exchange it, your ability to claim depreciation ends.

How to Calculate Depreciation of a Rental Property

Here are some more details to help you with calculating depreciation of your rental property:

Basis of depreciable property

When calculating depreciation, take the property’s purchase price, add the cost of capitalized improvements, and then subtract any tax credits received. You must also deduct the lot’s land value. Keep in mind that land value does not depreciate.

The formula is:

Purchase price + improvement costs – tax credits = Basis of depreciable property

Plugging in numbers to the formula for a house that originally cost $200,000, required minor improvements, and had some tax credits will look like this:

$200,000 + $5,500 – $1,500 = $204,000

Cost basis

The property’s cost basis is the amount originally invested, plus any associated fees. You can figure the cost basis by taking the amount you pay to purchase a rental property and adding any costs that you incurred to prepare the property for rental. It’s important to talk to a tax professional to understand which fees you can count as part of the cost basis.

Basis other than the cost basis

If you incur fees for acquiring a property other than the cost basis, these must figure into the amount you can depreciate for the rental property. These may be legal fees, title transfer fees, or other qualified closing costs, but some of these costs can be depreciated as part of the cost of owning and maintaining the property.

Such fees include:

• Charges for installing utility services
• Recording fees
• Settlement fees
• Surveys
• Title insurance
• Transfer taxes

Amounts owed by the seller that you agree to pay may become additions to your cost basis. These include improvement or repair fees and sales commissions.

Adjusted basis

Your cost basis is likely to change during the time you own a rental property, which is called your adjusted basis. The deductions to calculate depreciation will ultimately cause you to adjust your basis, as they reduce the cost of ownership and value of the property.

Zoning costs, legal fees, tax credits, and insurance reimbursem*nts are other factors that play into an adjusted basis. The adjusted basis can increase or decrease the property’s basis.

Electing an alternative depreciation system (ADS)

An alternative depreciation system (ADS) allows you to extend the recovery time you have to depreciate an asset. This can be beneficial to investors with rental properties, especially if they have multiple properties that fall into the same class. In some cases, this strategy can help you lower your taxes.

Property classes under a general depreciation system (GDS)

Most rental properties will fall under the GDS if they’re put into use after 1986. So unless you elect to use the ADS, which may be required in some cases, your rental property depreciation recovery period will be calculated using the GDS.

Recovery period under GDS

Determining the recovery period under GDS will depend on the type of asset you’re depreciating and the class of the property. Most rental properties put in use have a 27.5-year recovery period, but nonresidential property put in use between 1986 and 1993 has a 31.5-year recovery period. A seven-year property is one that doesn’t fall into any other property class. It’s important for property owners to understand the recovery period for their property to maximize the depreciation they can use.

Calculating rental property depreciation using MACRS

Investors who own property placed into service prior to Dec. 31, 1986, generally use the Modified Accelerated Cost Recovery System (MACRS) depreciation method. This depreciation method allows an investor to take more depreciation in the early years of a property’s holding period. It can be a bit more complicated to use this method to calculate depreciation, so make sure to consult an accountant.

With residential rental properties put in service prior to 1986, depreciation is for the useful life of the property over 27.5 years. So you’ll use 27.5 years for calculating the amount you can depreciate each year the asset is in service.

Calculating straight-line depreciation

While several different real estate depreciation methods exist, the appropriate depreciation strategy for you depends on the type of property you own and how old it is. The most common type is straight-line depreciation, which steadily depreciates the property over a number of years. This is the most general real estate depreciation system and usually the simplest to use.

Here’s how to calculate straight-line depreciation:

(Asset purchase price – salvage value) / useful life

Let’s define those terms:

• Asset purchase price: How much you paid for the asset.
• Salvage value: How much you think the property will be worth once it’s fully depreciated.
• Useful life of the property: How long the property can be depreciated, also known as the recovery period.

For real estate investors, the IRS has helpfully defined the useful life schedules:

• Residential rental property placed into service after Dec. 31, 1986: 27.5 years.
• Commercial rental property placed into service after Dec. 31, 1986, but before May 13, 1993: 31.5 years.
• Commercial rental property placed into service on or after May 13, 1993: 39 years.

If none of these categories fit your property, check out the IRS’s seven property classes.

Generally, for every full year you own residential real estate, you can depreciate it by 3.636%. So if you buy a property that is worth $100,000 after you subtract the land value, annual depreciation will be $3,636 per year.

Which System to Use

Deciding between the ADS and GDS will depend on your tax strategy and the type of property. Of course, most of the time, you’ll use a GDS, as it’s the standard method that applies to rental properties.

However, in the following cases, ADS is mandatory:

• The property is mainly used for farming.
• The property is financed by tax-exempt bonds or has a tax-exempt use.
• The property is used as a business 50% or less of the time.

You can also opt to elect ADS if you feel it will allow for more depreciation deductions. Discuss your options with a qualified tax accountant, who can help you make the right choice for your situation.

Claiming the Special Depreciation Allowance

Some rental property may qualify for a special depreciation allowance that lets you recover a portion of the cost of the property for the tax year that it’s placed in service. This special depreciation allowance applies to some properties acquired before September 2017 and some acquired after that time. The terms for claiming this special depreciation are very specific, so you’ll need to ensure that your property qualifies before you use this allowance.

How Much Does Rental Property Depreciation Reduce Tax Liability?

Regardless of your income, tax law always allows you to use rental property depreciation to offset your income from rent.

Let’s say your income was $1 million this year. You own a residential rental property with both income and depreciation expenses. Luckily, the depreciation expenses can be used to offset your rental income exactly the same way as if your total income was $10,000 for the year.

Some investors worry that higher incomes limit depreciation tax advantages, but this isn’t necessarily true. There is never a limitation on how much depreciation you can use to offset rental income.

But what happens if you have an overall net loss on your rentals? Let’s say you have a cash flow-positive rental property that provides you with $5,000 per year. By using tax strategies to maximize your write-offs, repairs, and depreciation expenses, you end up with a net tax loss of $2,000. The question is whether the $2,000 excess loss can be used to offset your other income.

Here is where the potential limitations come in. The IRS rules that if you do not spend more time in real estate than your other job or business, you can use up to $25,000 of your excess rental losses to offset your other income if your income is under $100,000.

If your income is between $100,000 and $150,000, you can still use your real estate losses to offset your other income. The amount you can use just may be limited. Once your income is above $150,000, you cannot use the excess losses to offset your other income. Those losses can offset future rental income.

Depreciation and taxes example

Adam works at a W-2 job where he makes $40,000 per year. With rental income of $20,000 and rental expenses of $30,000, Adam has a net rental loss of $10,000. Since his income is under the IRS threshold, he can use the $10,000 of excess losses to offset his W-2 income. If Adam makes $200,000, he cannot use the $10,000 excess loss to offset his W-2 income.

Important note: We are not saying Adam can’t write off his depreciation or expenses—he certainly can! He can use his depreciation and expenses to reduce the entire $20,000 of rental income. However, he cannot use the excess $10,000 to offset his W-2.

Adam pays no taxes on the $20,000 of rental income he received during the year, regardless of how much money he makes through his W-2 job.

Reducing income taxes using capital gains

If you make more than $150,000 a year, there are still ways to take advantage of depreciation. You can apply unused depreciation to a particular property you’ve sold, producing a capital gain. Though you’ll owe capital gains tax, the property’s unused depreciation will now break the IRS shackles and rush to the aid of that year’s ordinary income.

Let’s say Adam has a W-2 job that pays $250,000. He sells a rental property that generates an impressive capital gain. However, during all those years when he couldn’t use depreciation to offset his income, he accumulated $100,000 of unused depreciation.

That $100,000 gets pushed immediately over to his job income, as the property producing said depreciation has been sold. Essentially, it “shelters” that investor by lowering the amount of taxable income and offsetting capital gains tax.

Regardless of your income, owning real estate could be an efficient investment for tax purposes. There are no limits to expenses, and depreciation can be used to offset rental income. In fact, if Adam owned three properties—some profitable and some not so profitable—the expenses and depreciation from one rental can be used to offset the income from another rental.

What Rental Property Can’t Be Depreciated?

There are rules when it comes to writing off depreciation. Here’s what does not qualify for a depreciation deduction on your tax return:

• Land: Dirt and rocks are still dirt and rocks 10 years down the line. Work with an accountant to determine what the structure is worth versus the land value, and only depreciate the structure.
• Personal residences: You can no longer depreciate property if you move in yourself.
• Fully depreciated properties: After 27.5 years, you can no longer depreciate a residential property.

Depreciation isn’t as complicated as it seems, but you must follow some pretty rigid guidelines to take full advantage of this tax strategy. You can really use depreciation to your advantage when you understand how it works. The tax benefits can help you realize your investment’s full potential. Discuss your investment strategy with your tax professional to learn more about using depreciation for maximum profits.