How Does Straight Line Depreciation for Real Estate Work?

Straight-line depreciation is an accounting method used to systematically deduct the cost of a real estate asset over a predetermined period. This method allows property owners to claim a non-cash expense, which reduces taxable income without an actual cash outlay. The consistent and predictable nature of this method simplifies tax planning for real estate investors.

Determining the Depreciable Basis

A property’s depreciable basis is the value used to figure depreciation, starting with the asset’s cost. This initial cost basis includes the purchase price plus certain settlement fees and closing costs paid by the buyer, such as:

• Legal and recording fees
• Abstract fees
• Surveys
• Title insurance

The property’s total cost must be allocated between the land and the building. The Internal Revenue Service (IRS) does not permit the depreciation of land because it lacks a determinable useful life. This allocation can be based on the property tax assessor’s valuation, which shows separate values for land and improvements, or a professional appraisal can be used.

Once the building’s value is isolated, that figure represents the starting point for the depreciable basis. For tax purposes, a building’s salvage value—its estimated worth at the end of its useful life—is considered to be zero. Therefore, the entire cost allocated to the building can be depreciated over its recovery period.

Calculating Annual Depreciation

The IRS mandates specific recovery periods, or useful lives, for depreciating real estate. For residential rental property, the recovery period is 27.5 years, while nonresidential real property must be depreciated over 39 years. The straight-line method is the only permissible option for these types of properties under the Modified Accelerated Cost Recovery System (MACRS).

To calculate the annual deduction, the property’s depreciable basis is divided by its assigned recovery period. For example, a residential rental property with a depreciable basis of $275,000 divided by the 27.5-year recovery period results in an annual depreciation expense of $10,000. This amount can be deducted from the property’s rental income each year.

A specific rule known as the “mid-month convention” applies to real estate depreciation. This convention treats all property placed in service or disposed of during a month as being placed in service or disposed of at the midpoint of that month. For the first year of ownership, you can only claim a partial month’s depreciation for the month the property was acquired, plus the remaining full months of the year. The same principle applies in reverse for the year the property is sold.

Reporting Depreciation and Recapture

The annual depreciation expense is reported to the IRS on Form 4562, Depreciation and Amortization. This form is filed along with your annual tax return and details the depreciation for all business or investment assets. It is a procedural requirement for claiming the deduction.

When a depreciated property is sold for a gain, a concept known as “depreciation recapture” comes into play. The IRS requires you to pay taxes on the depreciation deductions you have claimed over the years. This is because those deductions lowered your ordinary taxable income, and the gain from the sale reflects that the property did not lose value as the depreciation suggested.

This recaptured amount is not taxed at the standard long-term capital gains rates of 0%, 15%, or 20%. Instead, it is taxed as “unrecaptured Section 1250 gain” at a maximum rate of 25%. For instance, if you sell a property and have a total gain of $100,000, of which $40,000 is from depreciation deductions you claimed, that $40,000 will be taxed at the 25% rate. The remaining $60,000 of the gain would be taxed at the applicable long-term capital gains rate.