How Depreciation Is Calculated Based on the Real Estate Value

Depreciation is a key tax benefit for real estate investors, allowing them to deduct the cost of wear and tear on a property over time. This non-cash expense reduces taxable income, providing financial advantages. However, calculating depreciation correctly requires understanding specific IRS rules.

Several factors influence depreciation, including which portions of the property qualify, how long they can be depreciated, and how improvements affect calculations. Investors must also consider strategies like cost segregation and the tax implications of selling a property.

The Depreciable Basis

Determining a property’s depreciable basis is the first step in calculating depreciation. This figure represents the portion of the purchase price and associated costs that can be written off over time. The basis includes the total acquisition cost, such as the purchase price, legal fees, title insurance, recording fees, and transfer taxes. These costs are capitalized, meaning they become part of the property’s value for depreciation rather than being deducted immediately.

Certain post-acquisition expenditures increase the depreciable basis. Structural additions, major renovations, and system upgrades—such as a new HVAC system—are added to the basis rather than expensed in the year incurred. The IRS differentiates between repairs, which are deductible immediately, and capital improvements, which must be depreciated. Misclassifying an expense can lead to incorrect tax filings and potential penalties.

The depreciable basis may also be adjusted downward. If a property is inherited, the basis is generally stepped up to its fair market value at the time of the previous owner’s death, potentially reducing or eliminating prior depreciation deductions. If received as a gift, the basis is typically carried over from the donor, meaning the recipient inherits the original depreciation schedule. Additionally, tax credits or grants for property improvements, such as energy efficiency incentives, may require a reduction in the depreciable basis to prevent double-dipping on tax benefits.

Land vs. Building Allocation

Depreciation applies only to the building and certain improvements, not the land. Accurately allocating value between land and structure is essential for compliance with IRS rules and maximizing deductions.

The allocation is typically based on the fair market value of each component at the time of purchase. Property tax assessments often provide a breakdown of land and building values, but these figures may not reflect market conditions accurately. Investors may seek independent appraisals or cost segregation studies to refine the allocation. Overestimating the land portion reduces depreciation benefits, while underestimating it can attract IRS scrutiny.

Lender appraisal reports often include a land-versus-building breakdown, which can serve as a reasonable basis for tax reporting. If a property is acquired as part of a bulk purchase, such as a portfolio acquisition, the allocation must be determined for each asset individually rather than applying a blanket percentage across all properties.

Recovery Period

The IRS defines depreciation time frames through the Modified Accelerated Cost Recovery System (MACRS). Residential rental properties are depreciated over 27.5 years, while commercial properties follow a 39-year schedule. These periods reflect IRS estimates of a building’s useful life for tax purposes, not its actual longevity. Once the full period has elapsed, depreciation deductions cease.

Depreciation begins when a property is placed in service, meaning it is available for rent or business use, regardless of whether tenants occupy it. The first year follows the mid-month convention, assuming the property was placed in service at the midpoint of the month acquired. This results in a partial month’s depreciation in the first and last years. If a property is sold before the full period is completed, depreciation stops in the month of sale, and only a prorated deduction is taken for that year.

Certain structural components, such as roofs, HVAC systems, and elevators, follow the same recovery period as the building. However, other assets, including appliances, carpeting, and landscaping, may qualify for shorter depreciation periods—typically five, seven, or 15 years—under MACRS rules. Identifying these components correctly can accelerate deductions and improve cash flow.

Adjustments for Improvements

Substantial property upgrades require adjustments to the depreciation calculation. The IRS differentiates between routine maintenance, which is deductible immediately, and capital improvements, which must be depreciated. Upgrades that enhance value, extend useful life, or adapt a property to a new use must be capitalized, affecting both the depreciation schedule and tax obligations.

The Tax Cuts and Jobs Act (TCJA) of 2017 introduced changes to how certain improvements are treated. Qualified Improvement Property (QIP), which includes interior non-structural enhancements to non-residential buildings, is eligible for a 15-year depreciation period and bonus depreciation. This allows investors to deduct 100% of the cost in the year improvements are placed in service, a provision available through 2026 before phasing out. However, exterior improvements, such as roofing or parking lots, do not qualify for this accelerated treatment and must follow standard depreciation rules.

Cost Segregation

Breaking down a property’s components into different asset classes can accelerate depreciation deductions. Cost segregation is a tax strategy that identifies portions of a building that qualify for shorter depreciation periods, allowing investors to front-load deductions rather than spreading them over decades. This approach is especially beneficial for commercial properties, where various structural and non-structural elements have different useful lives under IRS guidelines.

A cost segregation study, typically conducted by a specialized firm, analyzes a property’s components to reclassify eligible assets into categories with shorter recovery periods. Items such as electrical systems dedicated to specific equipment, decorative lighting, specialized plumbing, and certain flooring materials may qualify for five-, seven-, or 15-year depreciation instead of the standard 39-year period for commercial buildings. The study must be well-documented to withstand IRS scrutiny. While the upfront cost can be significant, the tax savings often justify the expense.

Beyond accelerating deductions, cost segregation enhances tax planning. If a property undergoes renovations or partial demolitions, previously segregated assets may be written off immediately as a loss rather than continuing to be depreciated. This strategy can also be combined with bonus depreciation provisions, allowing investors to deduct a substantial percentage of qualifying assets in the first year. Given the complexity of these rules, consulting a tax professional is advisable to ensure compliance and maximize benefits.

Depreciation Recapture

While depreciation provides tax benefits during ownership, it creates potential tax liabilities when a property is sold. Depreciation recapture is the process by which the IRS recoups some of the tax benefits previously claimed, requiring investors to pay taxes on the portion of the gain attributable to prior depreciation deductions.

For real estate, depreciation recapture is taxed as ordinary income, with a maximum rate of 25% under Section 1250 of the Internal Revenue Code. This applies to the portion of the gain resulting from depreciation deductions on the building itself. If cost segregation was used to accelerate depreciation on certain assets, those components may be subject to higher recapture rates under Section 1245, which taxes personal property recapture at ordinary income rates, potentially up to 37%.