What Is Rental Property Depreciation And How Does It Work?

As a real estate investor, rental property depreciation is an important concept to understand because depreciation can help you keep more money in your pocket by significantly reducing your income taxes.

Depreciation can also help investors 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.

Let’s take a look at what rental property depreciation is, how it works and how you can calculate it yourself.

What Is Rental Property Depreciation?

Rental property depreciation is a basic accounting principle that allows you to deduct the cost of a rental property over a set period of time. The Internal Revenue Service (IRS) assumes a rental property will lose a certain amount of value every year (typically 3.6%).

For as long as you own the property, this loss (known as depreciation), can be subtracted from your taxable income every year. This, in turn, can lower your taxes and may even drop you into a lower tax bracket.

How Does Rental Property Depreciation Work?

When you buy rental property to add to your financial portfolio, you can expect to pay out a large sum of money to purchase the real estate. In return for your initial outlay of cash, the IRS has put tax rules in place that offset the cost of the property by factoring in the assumed drop in the property’s value over time. However, the IRS won’t allow you to take the tax deduction all at once.

If you own a rental property, the federal government allows you to claim the depreciation of the property every year for 27.5 years. If you use the property for business or farming for more than 1 year, you can deduct the depreciation on your tax return over a longer period.

What Is Depreciation?

Here’s the central concept of depreciation: most tangible assets (valuable material property) are depleted through usage or decay over their lifespan. The wear and tear reduces the value of the asset as time passes. It’s assumed the asset, such as a piece of real estate, won’t remain in pristine condition.

What Is The Depreciation Recovery Period?

The recovery period, which is the time frame when depreciation can be claimed, is different for real estate assets versus other types of assets. 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.

How Do You Calculate Annual Depreciation?

To determine your annual depreciation amount, you must divide the cost basis and value of your property by its recovery period. Note that only the structure or building is depreciable – not the land the building sits on. Only buildings have a useful lifespan, and land never loses value to depreciation.

You can continue to claim depreciation during the recovery period until the property is sold to another party or your total cost basis has been fully depreciated.