Calculating Your Real Estate Depreciation Schedule

Real estate depreciation is a tax deduction allowing property investors to recover the cost of an income-producing property over its designated useful life. This non-cash deduction spreads the property’s acquisition cost over many years, reducing the taxable income reported annually. This process lowers the owner’s yearly tax liability and improves cash flow from the investment.

Determining the Depreciable Basis

Before calculating any annual deduction, an investor must establish the property’s depreciable basis. The basis begins with the property’s purchase price, but it also includes various settlement and closing costs incurred during the acquisition. These allowable additions can include legal and recording fees, abstract fees, surveys, transfer taxes, owner’s title insurance, and any amounts the seller owes that the buyer agrees to pay.

Certain expenses from the closing process are excluded from the cost basis calculation. These non-allowable costs include payments for casualty insurance premiums, prorated real estate taxes, and charges for services like utilities paid for at closing. These items are deducted in the year they are paid as rental expenses rather than being added to the property’s basis.

A principle of real estate depreciation is that land itself is not depreciable because it does not wear out or become obsolete. An owner must allocate the total acquisition cost between the physical building and the land to isolate the value of the depreciable assets.

The most common method for allocating the property’s cost is to use the ratio of land-to-building value from the local property tax assessor’s office. For example, if the assessor values the land at $50,000 and the building at $200,000, the building represents 80% of the total assessed value. An investor who purchased the property for $300,000 would then allocate 80% of that purchase price, or $240,000, as the depreciable basis for the building. Alternatively, a formal property appraisal can be used to determine the respective values.

Calculating Annual Depreciation

The primary system for calculating depreciation on real estate is the Modified Accelerated Cost Recovery System (MACRS), which is mandated for most rental properties placed in service after 1986. Under MACRS, the cost of a property is recovered using the straight-line method, which means the depreciation deduction is spread evenly over the asset’s designated recovery period.

MACRS establishes specific recovery periods for different types of real property. For residential rental property, the recovery period is 27.5 years. A property qualifies as residential rental if 80% or more of its gross annual rental income comes from dwelling units. For nonresidential real property, such as office buildings or warehouses, the recovery period is 39 years.

A rule known as the “mid-month convention” applies to real estate depreciation calculations under MACRS. This convention treats all property placed in service during a given month as if it were placed in service on the 15th of that month. For the first year of ownership, the depreciation deduction is prorated, and the owner can only claim a half-month’s depreciation for the month the property was acquired.

To illustrate, consider a residential rental property with a depreciable basis of $275,000, placed in service in June. The annual depreciation for a full year would be $10,000 ($275,000 / 27.5 years). Due to the mid-month convention, the first-year deduction is prorated for 6.5 months (mid-June to December). The deduction would be ($10,000 / 12 months) 6.5 months, resulting in approximately $5,417. For each of the subsequent 26 years, the owner would claim the full $10,000 deduction.

Reporting Depreciation on Tax Forms

The annual depreciation amount is reported on Form 4562, “Depreciation and Amortization.” This form is filed with the investor’s tax return, along with Schedule E for reporting rental real estate income and expenses.

The specific section of Form 4562 used depends on when the property was placed in service. For property placed in service during the current tax year, the details are entered in Part III, Section C. If the property was placed in service in a prior tax year, the information is reported in Part III, Section B.

When completing the form, the following information is required for each depreciable asset:

• A description of the property
• The date it was placed in service
• Its cost or other basis
• The recovery period (27.5 or 39 years)
• The depreciation method (MACRS)
• The convention used (mid-month)
• The calculated depreciation deduction for the year

Depreciation Recapture Upon Sale

While depreciation provides an annual tax benefit, it has consequences when the property is sold. The IRS uses a process called depreciation recapture to tax the portion of the gain attributable to the depreciation deductions taken. This prevents property owners from reducing ordinary income annually and then having the entire gain taxed at lower long-term capital gains rates.

When a property is sold, the owner must calculate their adjusted cost basis. This is the original cost basis minus the total accumulated depreciation that was claimed over the ownership period. The total gain on the sale is the sale price minus this adjusted cost basis.

This recaptured amount is called “unrecaptured Section 1250 gain” and is taxed at a maximum rate of 25%, which is higher than the standard long-term capital gains rates of 0%, 15%, or 20%. Any remaining gain on the sale is treated as a standard long-term capital gain and taxed at the lower applicable rates.

For example, an investor bought a property with a basis of $250,000 and claimed $50,000 in depreciation. Their adjusted basis becomes $200,000. If they sell the property for $320,000, their total gain is $120,000 ($320,000 sale price – $200,000 adjusted basis). Of this gain, the first $50,000 is subject to the 25% recapture tax, and the remaining $70,000 is treated as a long-term capital gain.