How to Calculate Property Depreciation?

Property depreciation is an annual tax deduction that allows owners to recover the cost of an income-producing property over its useful life. This process acknowledges the wear and tear on a building as it ages, creating a non-cash expense that lowers annual taxable income for investors and business owners. The deduction is calculated by spreading the property’s acquisition cost over a set number of years.

Gathering Key Information for Depreciation

Before calculating, you must gather specific details about your property. A property is eligible for depreciation if you own it, use it in a business or income-producing activity, and it has a useful life of more than one year.

You must determine the property’s basis, the figure used for the calculation. The initial cost basis is the purchase price plus certain settlement and closing costs, like legal fees and surveys. This figure becomes an “adjusted basis” if it increases with major improvements or decreases by depreciation previously claimed.

Land is not depreciable because it does not wear out, so its cost must be separated from the building’s cost. To allocate the total purchase price, you can use the assessed values for land and building from your local property tax assessor. For example, if the assessor values the land at 20% of the total property value, you would allocate 20% of your purchase price to land and 80% to the building.

The “placed-in-service” date is when the property was ready and available for its intended use, not necessarily when you bought it. This date is the starting point for depreciation and dictates which annual depreciation rate to use from the IRS tables.

The MACRS Framework for Property

The Internal Revenue Service (IRS) requires owners to use the Modified Accelerated Cost Recovery System (MACRS) for most property placed in service after 1986. This system provides the mandatory rules for calculating depreciation.

MACRS is divided into two subsystems: the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). GDS is the most common method. ADS has a longer recovery period and is mandatory for certain properties, such as those used 50% or less for business. An owner can also elect to use ADS, but this choice is irrevocable.

Under GDS, the recovery period for residential rental property is 27.5 years. This applies if 80% or more of its gross rental income comes from dwelling units. For nonresidential real property, like an office building or warehouse, the recovery period is 39 years.

MACRS also requires using the “mid-month convention.” This rule treats property as placed in service in the middle of the month, regardless of the actual date. This means for the first year, you claim a half-month of depreciation for the month the property was placed in service, and the same rule applies to the month of disposal.

Calculating Your Annual Depreciation Deduction

With the building’s basis, recovery period, and placed-in-service date, you can calculate the annual deduction. The IRS provides percentage tables in Publication 946, How to Depreciate Property, to simplify this calculation.

For a residential rental property with a 27.5-year recovery period, you will use the GDS straight-line, mid-month convention table. This table provides a different depreciation rate for each year, and the rate for the first year depends on the month the property was placed in service.

Multiply the building’s basis by the depreciation rate for the current year from the table. For example, a residential rental property with a $280,000 building basis placed in service in June uses the Year 1, Month 6 rate of 2.273%. The first-year deduction would be $280,000 multiplied by 0.02273, which equals $6,364.40.

For a full year of service (Years 2 through 27 for a residential property), the depreciation rate is 3.636%. Using the same example, the deduction for the second year would be $280,000 multiplied by 0.03636, for a total of $10,180.80. This amount is claimed annually until the final years of the recovery period.

Reporting Depreciation to the IRS

The depreciation deduction must be reported to the IRS on your annual tax return using Form 4562, Depreciation and Amortization. This form is used to report the details of your depreciable property and the deduction amount for the year.

For real property, complete Part III of Form 4562. You will enter the placed-in-service date, basis, recovery period, convention, and depreciation method. The final column is for the calculated depreciation deduction.

After completing Form 4562, the total depreciation deduction is transferred to another part of your tax return. For a residential rental property, this amount flows to Schedule E, Supplemental Income and Loss. For property used in a business, the deduction is carried to Schedule C, Profit or Loss from Business.