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What Is Rental Property Depreciation?

Hanna Kielar8-minute read

June 10, 2022

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When tax time approaches, property owners always look for ways to reduce their income tax bills or reduce their overall taxable income.

That’s where rental property depreciation can help. It allows you to increase the return on your real estate investment in homes, condominiums, apartments and other investment property holdings.

In real estate terms, rental property depreciation is a basic accounting principle that effectively allows you to deduct the cost of a large asset with a useful life of one year or more over a longer period of time. In effect, rental property depreciation (thanks to the phantom expenses it provides) can help provide tax advantages by offering you a means to move into a lower tax bracket or do away completely with any income tax bills you might otherwise face.

Depreciation often provides a handy way for investors to maximize their gains on any given piece of property while also minimizing out-of-pocket expenses. These tax benefits may factor heavily into your decision to invest.

What Is Rental Property Depreciation?

When you buy a piece of rental property to add to your financial portfolio, you can expect to lay out a large sum of money to purchase the real estate. However, the Internal Revenue Service (IRS) tax rules do not allow you to take such a large amount in tax deductions all at once. Rather, property used for business or investment purposes, which has a useful life of more than one year, is deducted over a longer period of time. Owners of rental properties are eligible to benefit from these processes.

Here’s the central concept of depreciation: Tangible assets are depleted through usage or decay throughout the life of the property. This reduces the value of a given asset as time passes. It’s assumed that – because it’s used and subject to wear and tear – a financial holding such as a piece of real estate no longer remains in pristine condition.

The period during which depreciation can be claimed, also known as the recovery period, is different for real estate assets than other types of assets, however. While less expensive items such as office equipment and furniture have a recovery period of 7 years, residential buildings are depreciable over 27.5 years and commercial properties have a 39-year recovery period.

To determine your annual depreciation amount, you can divide the cost basis and value of your property over this preset number of years. Note that only the value of the structure or building itself (not the land it’s situated upon) can be deducted, as only buildings have a useful lifespan. You can continue to claim depreciation over this predesignated time period until the property has been sold to another party or your total cost basis has been fully depreciated.

Who Is Eligible To Claim Rental Property Depreciation?

To claim depreciation on your rental properties, you must first meet the following requirements:

  • You must own the property (either outright or as you pay off debt).
  • You must use the property in your business or as part of an income-producing activity.
  • Your property has a determinable useful life – in other words, its value will decline or be depleted over time.
  • The property is expected to have a useful life that exceeds at least one year.

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How Is Rental Property Depreciation Calculated?

Read on to see how rental property depreciation works and can be calculated as you look to offset taxable income.

Step 1: Determine Your Cost Basis In The Building

Note that your cost basis in a rental property is different from the actual price paid.

At Purchase

The cost basis is the total capital expense of the property minus the value of the land on which it sits. Only certain items like legal, abstract or recording fees, as well as any seller debts that a buyer agrees to pay, qualify as a capital expense when calculating this sum.

As Improvements Are Made

Also be aware that the costs of any improvements to the property are added in the year they are incurred to determine the adjusted cost basis.

Step 2: Calculate The Amount Of Annual Depreciation

The Modified Accelerated Cost Recovery System (MACRS) is the accounting system that is used for all residential buildings put into service since 1986. These properties use the General Depreciation System (GDS) outlined under its terms for purposes of calculating annual depreciation amounts.

Alternatively, for properties put into use prior to 1987, you can calculate depreciation by using the Accelerated Cost Recovery System, which is beyond the scope of this article. If you’re using this system, consult accountants familiar with this depreciation method.

General Depreciation System (GDS)

Under the rules of the MACRS framework, most taxpayers will use GDS. As explained in its rules, there is a 27.5-year recovery period afforded for residential rental properties, and a 39-year recovery period for commercial rental properties. GDS applies straight line depreciation to both residential and commercial rental properties – in other words, you can divide the value of your property over this period to calculate annual depreciation amounts.

Alternative Depreciation System (ADS)

Taxpayers must use the ADS method of depreciation instead if the property:

  • Is used for a qualified business purpose only 50% or less of the year
  • Has a tax-exempt use
  • Is financed by tax-exempt bonds
  • Is used primarily for agricultural/farming purposes

Rental property owners who believe that they must use ADS should consult an accountant to determine the best way to depreciate their property. Note that the 2017 Tax Cuts and Jobs Act shortened the recovery period for taxpayers using ADS from 40 years to 30 years.

Deductions Vs. Depreciation

Deductions are paid expenses that can be deducted from your income taxes in the same year that they’re incurred.

Depreciation, however, functions as a form of non-cash deduction whose total amount is amortized over a period of several years and can reduce an investor’s taxable income by a maximum set amount in any given year.

For example: Replacement light bulbs that you buy for your rental property are an expense. New light fixtures that you install (and add to the value of the property) can be depreciated over time instead.

Depreciation functions as a way to receive the benefits of incurring an expense without actually paying any additional monies out of pocket or writing a check – it essentially lets you take tax deductions on the perceived decrease in value over time of real estate holdings.

On the flip side, an operating expense is a cost required as part of day-to-day business functioning, whereas a capital expense is a cost that you incur to create future benefits. To qualify as a capital expense, an item purchased for your rental property must have an expected life of more than one year.

Rental Property Depreciation FAQs

Want to know more about rental property depreciation? Here are some answers to frequently asked questions.

When can I start taking depreciation?

Depreciation begins immediately after a property becomes available for rent or is placed into commercial use. For example, say Taylor purchases a rental property on March 1, 2021, but doesn’t begin renting it out until March 15, 2021, at which time a new lease with their tenant Jordan begins. They can begin depreciating the property on March 15. Note that when service begins during a calendar year that has already started, the amount of depreciation available to you is prorated for this first-year term. For example, see the following chart, drawn from IRS Publication 527, pertaining to residential rental property:

January

3.845%

February

3.182%

March

2.879%

April

2.576%

May

2.273%

June

1.970%

July

1.667%

August

1.364%

September

1.061%

October

0.758%

November

0.455%

December

0.152%

How long does depreciation last?

The period during which property owners can take depreciation is known as the recovery period. The recovery period lasts until the cost basis, including any adjustments, is depleted. However, keep in mind that investors who continue to improve their properties are able to continually adjust their cost basis as they go.

If I deplete my cost basis with depreciation, won’t I have to pay capital gains taxes on the proceeds of a future sale of the property (1031 exchanges)?

If you desire to reinvest the proceeds into a new investment property (in accordance with IRS regulations), you may defer taxes on the capital gains through a 1031 exchange. However, if the 1031 exchange is done incorrectly, taxpayers could face depreciation recapture and a hefty tax bill. In addition, you may wish to also keep in mind that investment properties located in opportunity zones also enjoy very favorable tax advantages.

What IRS forms do I file in order to claim depreciation?

To claim rental property depreciation, you’ll need to file IRS Form 4562 to obtain your deduction. Review the Instructions for Form 4562 if you are filing it yourself or consult a qualified financial advisor or tax accountant if you need assistance.

Suppose I buy new appliances for my rental properties. How would I deduct those expenses??

New appliances would not qualify as expenses because they have an expected useful life of 5 years. In effect, taxpayers have the choice of either depreciating the cost of the appliances over 5 years or adding the cost of the appliances to their cost basis and continuing to depreciate against the now-adjusted cost basis.

The Bottom Line

While rental property depreciation can’t all be claimed at once, it can provide a handy tool over time for helping you reduce your taxable income. Likewise, the practice of rental property depreciation can also provide a way to keep more money in your pocket and increase your financial portfolio, without having to come out of pocket on added ongoing costs.

Curious about how to invest in real estate or learn about other tax advantages that may be available to you as a potential real estate investor? Feel free to speak or chat with one of our Home Loan Experts today.

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Hanna Kielar

Hanna Kielar is a Section Editor for Rocket Auto, RocketHQ, and Rocket Loans® with a focus on personal finance, automotive, and personal loans. She has a B.A. in Professional Writing from Michigan State University.