How to Calculate Real Estate Depreciation

Real estate depreciation is a tax deduction that allows investors to recover the cost of an income-producing property over a set period. This process acknowledges the wear and tear a building experiences, even as its market value might increase. It functions as a non-cash expense, meaning you can deduct it from your rental income without an actual cash outlay each year. This reduction in taxable income is a benefit for real estate investors, enhancing cash flow.

Determining Your Property’s Depreciable Basis

Before calculating your annual depreciation deduction, you must establish the property’s depreciable basis. The starting point is the cost basis, which is the amount you paid for the property plus certain settlement fees and closing costs. These can include expenses such as legal and recording fees, abstract fees, surveys, transfer taxes, title insurance, and any amounts the seller owes that you agree to pay.

A rule of real estate depreciation is that land is not depreciable. Therefore, you must separate the cost basis of the property between the land and the building. A common method for this is to use the ratio from the local property tax assessment. For instance, if the tax assessment values the building at 80% of the total property value, you would allocate 80% of your total cost basis to the building.

Another element is the “placed-in-service date,” which is the date the property is ready and available to be rented. This date is not necessarily when a tenant moves in, but it determines when you can begin taking depreciation deductions. The placed-in-service date is used in the first year’s calculation to prorate your deduction.

The Depreciation Calculation Method

The Internal Revenue Service (IRS) requires using the Modified Accelerated Cost Recovery System (MACRS) for properties placed in service after 1986. Most real estate investors will use the General Depreciation System (GDS) under MACRS.

Under GDS, the IRS assigns a “recovery period,” which is the number of years over which you can depreciate the property. For residential rental properties, the recovery period is 27.5 years. For nonresidential real property, such as commercial buildings, the recovery period is 39 years.

A rule within MACRS that impacts the first and last year of ownership is the “mid-month convention.” This rule treats all real property as placed in service or disposed of in the middle of the month, regardless of the actual day. For example, if you place a rental property in service on any day in May, you are considered to have started using it on May 15th for tax purposes.

Step-by-Step Calculation Example

Imagine you purchase a residential rental property for $350,000 and incur $5,000 in closing costs that can be added to your basis. This brings your total cost basis to $355,000.

Next, you must separate the value of the land from the building. Using the local property tax assessment, you find the land is valued at $71,000 and the building at $284,000, a 20/80 split. Applying this ratio to your $355,000 cost basis, the building’s depreciable basis is $284,000.

With a depreciable basis of $284,000 and a 27.5-year recovery period, the full annual depreciation deduction is $10,327 ($284,000 / 27.5 years). This is the amount you could deduct if the property were in service for the entire year.

However, you must apply the mid-month convention for the first year. If you placed the property in service on June 10th, you can claim depreciation for 6.5 months. To find the first-year deduction, determine the monthly depreciation ($10,327 / 12 = $860.58) and multiply it by the months in service ($860.58 x 6.5 = $5,593.77).

Reporting Depreciation and Recapture

The annual depreciation amount is calculated on IRS Form 4562, Depreciation and Amortization. On this form, you list the property, its basis, the placed-in-service date, and the depreciation method. The final deduction is then carried over as an expense on Schedule E (Form 1040), which reports income and expenses from rental real estate.

When you sell the property, you must account for the depreciation claimed over the years through a process called depreciation recapture. This is reported on IRS Form 4797, Sales of Business Property. The total amount of depreciation you took is taxed at a maximum rate of 25%, which can be higher than long-term capital gains rates.

For example, if your total gain on a sale is $100,000 and you had claimed $60,000 in depreciation, that $60,000 is subject to the 25% recapture tax. The remaining $40,000 of the gain would be taxed at the applicable long-term capital gains rate. This process ensures the tax benefit from depreciation is paid back when the asset is sold.