How Does Depreciation on Real Estate Work?

Depreciation is a tax deduction for owners of income-producing properties that accounts for gradual wear and tear. It allows you to deduct a portion of a building’s cost over its expected lifespan. This is a non-cash deduction, meaning you do not spend money to claim it, but it reduces your taxable rental income and overall tax liability each year.

Determining Your Depreciable Basis

The starting point for any depreciation calculation is the property’s basis. For real estate, this is its cost basis, which is the amount you paid for the property, including the purchase price and certain other expenses. These additional costs can include:

• Legal fees
• Recording fees
• Surveys
• Transfer taxes
• Title insurance

You cannot include costs that you deduct separately as expenses, such as property taxes or insurance.

A primary rule of real estate depreciation is that land is not depreciable because the IRS considers it an asset that is not consumed over time. You must separate the property’s total acquisition cost between the land and the building, as only the cost allocated to the building creates the depreciable basis.

One common method to allocate the value is using the assessed values from your local property tax assessor, which show separate values for land and the building. You can apply the building’s percentage of the total assessed value to your total purchase price to determine the building’s basis.

Another method is to get a formal appraisal from a qualified appraiser, which can provide a more precise valuation. The cost of the appraisal can often be added to the property’s basis. Whichever method you choose, you should maintain clear records supporting your allocation.

Qualifying Real Estate for Depreciation

For a property to be eligible for depreciation, it must meet four specific IRS criteria.

• You must be the owner of the property, even if it is subject to a mortgage.
• You must use the property in a business or income-producing activity, such as holding it for rent.
• The property must have a determinable useful life, meaning it is an asset that wears out or loses value from natural causes.
• The property must be expected to last for more than one year, which distinguishes it from a current expense.

Property used exclusively as your personal residence does not qualify. If you use a property for both rental and personal purposes, you must divide the expenses, and only the rental-use portion can be depreciated. Qualifying real estate includes residential rental properties like single-family homes and apartment buildings, and commercial properties such as office buildings, warehouses, and retail stores.

Calculating Real Estate Depreciation

The IRS requires using the Modified Accelerated Cost Recovery System (MACRS) to depreciate real estate. For residential and nonresidential properties, MACRS uses the straight-line method, spreading the deduction evenly over a set number of years.

Under MACRS, the IRS assigns specific recovery periods to different property types. For residential rental property, where 80% or more of the gross rental income comes from dwelling units, the recovery period is 27.5 years. For nonresidential real property, which includes office buildings and warehouses, the recovery period is 39 years. These periods are fixed and do not change based on the building’s physical condition.

MACRS also uses a mid-month convention for the first and last years of service. This rule treats any property placed in service or disposed of during a month as if it happened in the middle of that month. For the first year, you receive a deduction for half of that month, plus the remaining full months of the year.

For example, consider a residential rental property with a depreciable basis of $275,000. The annual depreciation deduction is found by dividing the basis by the recovery period ($275,000 / 27.5 years), which equals $10,000 per year. If you placed the property in service in June, the mid-month convention allows you to claim 6.5 months of depreciation, resulting in a first-year deduction of approximately $5,417.

Reporting Depreciation and Recapture

You claim annual depreciation on IRS Form 4562, Depreciation and Amortization. The total depreciation for a rental property is then carried over as an expense to Schedule E (Form 1040), which is used to report income and expenses from rental real estate.

When you sell a depreciable rental property, you must address depreciation recapture. This is the process the IRS uses to tax the total depreciation you claimed during your ownership, preventing a double tax benefit.

The depreciation you have taken lowers your property’s adjusted cost basis. For example, if your initial basis was $300,000 and you claimed $50,000 in depreciation, your adjusted basis becomes $250,000. If you sell the property for $350,000, your total gain is $100,000, which is composed of $50,000 of depreciation recapture and $50,000 of capital gain.

The recaptured portion of the gain is taxed differently than standard capital gains. The IRS taxes this gain, known as unrecaptured Section 1250 gain, at a maximum rate of 25%. This rate is often higher than long-term capital gains rates. You are required to recapture all allowable depreciation, even if you failed to claim it on your tax returns.