Depreciating Residential Rental Property Under Section 168

Owners of income-producing real estate can recover their investment cost over time through an annual tax deduction for depreciation, which accounts for the property’s gradual wear and tear. The framework for this deduction is outlined in Internal Revenue Code Section 168, which establishes the Modified Accelerated Cost Recovery System (MACRS). MACRS is the required method for depreciating most tangible property.

For investors in rental housing, understanding these rules is part of managing their assets and tax obligations. The system uses specific recovery periods and calculation methods that vary by property type to determine the annual depreciation expense, which can reduce an owner’s taxable rental income.

Defining Residential Rental Property

A building qualifies as residential rental property if at least 80% of its gross rental income for the tax year comes from dwelling units. This 80% gross rental income test is applied annually, so a property’s classification can change from year to year.

Gross rental income includes all amounts received for the use of real property, such as monthly rent and fees for parking or laundry. A dwelling unit is a house or apartment that provides living accommodations, but it does not include units in hotels or motels where over half the units are used by transients.

For instance, consider a duplex where the owner lives in one unit and rents out the other. To apply the test, the owner must include the fair rental value of their own unit as part of the building’s total gross rental income. If a property fails this test, such as a mixed-use building with substantial commercial space, it is classified as nonresidential real property and is subject to a longer depreciation schedule.

Determining the Depreciable Basis

A property’s depreciable basis is the figure used to calculate the annual depreciation expense. For a purchased property, the basis starts with its cost, which is the amount paid for the property, including any debt assumed from the seller. This initial cost is then adjusted by adding certain settlement fees and closing costs necessary to complete the purchase. These includable costs are:

• Legal and recording fees
• Abstract fees
• Surveys
• Transfer taxes
• Title insurance
• Any amounts the seller owes that the buyer agrees to pay

It is important to distinguish these from costs that cannot be included in the basis, such as fees related to obtaining a mortgage, credit report fees, and property insurance premiums. These financing-related costs are not considered part of the property’s acquisition cost.

A critical step is allocating the total cost between the building and the land, as land is not depreciable. If the purchase contract does not specify this allocation, a reasonable method is to use the ratio of the land’s assessed value to the building’s assessed value from local property tax records.

For example, if a property is purchased for $300,000 and tax records show the building is 80% of the total assessed value, the owner would allocate 80% of the purchase price ($240,000) as the building’s basis. This figure, plus the allocated portion of includable closing costs, becomes the depreciable basis.

Calculating Depreciation Under MACRS

The annual depreciation deduction is calculated using the Modified Accelerated Cost Recovery System (MACRS). For residential rental property, the General Depreciation System (GDS) is used unless specific circumstances require an alternative. GDS for this property type is defined by three components: a 27.5-year recovery period, the straight-line method, and the mid-month convention.

The 27.5-year recovery period is the timeframe over which the owner will recover the cost basis of the property. The straight-line method ensures that the depreciation deduction is spread evenly over the recovery period, providing a predictable tax benefit. The mid-month convention applies to the first and last years of the property’s service life, treating all property placed in service during a month as being placed in service at the midpoint of that month.

To illustrate, consider a property with a depreciable basis of $275,000. The full annual depreciation is calculated by dividing the basis by the recovery period: $275,000 / 27.5 years = $10,000 per year. If the property is placed in service on June 10, it is treated as being in service for 6.5 months in the first year. The first-year deduction would be ($10,000 / 12 months) 6.5 months = $5,417. For each of the subsequent 26 full years, the owner would deduct the full $10,000. The annual depreciation is reported on IRS Form 4562, Depreciation and Amortization.

Accounting for Property Improvements

Expenditures on a rental property are categorized as either repairs or improvements, which affects their tax treatment. A repair is an expense that keeps the property in good operating condition but does not materially add to its value or substantially prolong its life. Examples include fixing a leaky faucet, repainting a room, or replacing a broken window pane. These repair costs are considered current operating expenses and can be fully deducted in the year they are paid.

An improvement is an expenditure that betters the property, restores it, or adapts it to a new use. For example, replacing an entire roof, adding a new deck, or remodeling a kitchen are all considered improvements. The cost of an improvement must be capitalized, meaning it is added to the property’s basis and depreciated over time.

The cost of an improvement to a residential rental property is depreciated using the straight-line method over a 27.5-year recovery period, starting from when the improvement is placed in service. Each improvement is treated as a separate asset with its own depreciation schedule. For instance, if an owner spends $15,000 on a new HVAC system five years after purchasing the property, that cost is an improvement and must be depreciated separately over 27.5 years, starting from the month of installation.

The Alternative Depreciation System (ADS)

While most taxpayers use the General Depreciation System (GDS), certain situations make the Alternative Depreciation System (ADS) mandatory. Its application is triggered by the specific use of the property or certain financing arrangements. The use of ADS is required for residential rental property in several circumstances, including if the property is:

• Used 50% or less for business in a given year
• Financed with tax-exempt bonds
• Used predominantly outside of the United States
• Owned by a real property trade or business that elects out of the business interest expense limitation under Section 163(j)

For residential rental property that must use ADS, the prescribed recovery period is 30 years. Despite the longer recovery period, ADS still requires the use of the straight-line method and the mid-month convention. The practical effect of using ADS is a slower cost recovery, as the total depreciation deductions are spread over a longer timeframe. If an owner chooses to use ADS when it is not required, the election is irrevocable and must be made in the first year the property is placed in service.