How to Claim Depreciation of Real Estate

Real estate depreciation is a tax deduction that allows investors to recover the cost of an income-producing property over its useful life. The deduction recognizes the wear and tear, deterioration, or obsolescence the property experiences. This mechanism allows property owners to offset rental income by systematically expensing the cost of the asset. This process treats the building as a long-term expense, acknowledging that its value as a structure diminishes over time, regardless of its market price.

Identifying Depreciable Real Estate

To be eligible for depreciation, a property must meet criteria set by the IRS. The owner must use the property in a business or income-producing activity, such as a rental, and it must have a determinable useful life, meaning it is expected to last for more than one year. Personal residences are not depreciable.

Land is also not depreciable because it does not have a useful life that gets “used up.” Therefore, only the structure and certain land improvements, like driveways or fences, can be depreciated. Qualifying properties include assets like apartment buildings, office complexes, warehouses, and retail stores.

The depreciation process begins when the property is “placed in service,” which is when it becomes ready and available for its intended use as a rental or business asset. This is not necessarily the purchase date but the date it is ready for tenants. An owner can continue to claim depreciation deductions until they have recovered their entire cost in the property or until they sell or otherwise dispose of it.

Establishing the Property’s Cost Basis

An owner must first establish the property’s cost basis. The basis is the amount paid for the property, including the purchase price and various other expenses connected with the purchase. These can include settlement fees and closing costs, such as legal fees, recording fees, surveys, and title insurance. Any subsequent capital improvements that add to the property’s value are also added to the basis.

The total cost basis must be allocated between the land and the building, as land cannot be depreciated. A common method for this allocation is to use the assessed values provided by the local property tax assessor. The ratio of the land’s assessed value to the building’s assessed value can be applied to the total purchase price. For instance, if the tax assessor values the land at $100,000 and the building at $300,000, the building represents 75% of the total assessed value. If the total purchase cost was $500,000, the basis for the building would be $375,000, and this figure becomes the “basis for depreciation.” An independent appraisal can also be used for this allocation.

Calculating the Annual Depreciation Deduction

The mandatory method for depreciating real estate placed in service after 1986 is the Modified Accelerated Cost Recovery System (MACRS). Under MACRS, real estate is depreciated using the straight-line method, which means the cost is deducted in equal amounts over the property’s recovery period.

The IRS assigns fixed recovery periods to different property types. For residential rental property, the recovery period is 27.5 years. For nonresidential real property, which includes commercial assets like office buildings and warehouses, the recovery period is 39 years.

The annual depreciation deduction is calculated by dividing the building’s cost basis by the applicable recovery period. For example, a residential rental property with a building basis of $275,000 would have an annual depreciation deduction of $10,000 ($275,000 / 27.5 years). This amount can be deducted each full year the property is in service.

A mid-month convention rule must also be applied, which treats all property as being placed in service in the middle of the month, regardless of the actual purchase date. This means the depreciation deduction is prorated for the first year of ownership. An owner who places a property in service in July would claim 5.5 months of depreciation for that tax year.

Reporting Depreciation to the IRS

The annual depreciation deduction is reported on Form 4562, “Depreciation and Amortization.” This form is used for the first year a property is placed in service and for any year an improvement is made. In Part III of Form 4562, the owner enters the property’s description, the date it was placed in service, its cost basis, the recovery period, the depreciation method, and the convention used.

The total depreciation amount from Form 4562 is then carried over to Schedule E (Form 1040), “Supplemental Income and Loss.” The depreciation expense is listed on Schedule E and subtracted from the gross rental income, which reduces the net taxable income from the property.

Understanding Depreciation Recapture

When a depreciated property is sold, the IRS uses a rule called depreciation recapture. Over the years of ownership, claimed depreciation deductions reduce the property’s adjusted cost basis, which leads to a larger calculated gain when the property is sold. The IRS “recaptures” the tax benefit of those deductions at the time of sale. The portion of the total gain attributable to the depreciation deductions is not taxed at the lower long-term capital gains rates. Instead, this portion of the gain is taxed at a maximum rate of 25%, which can result in a higher tax liability than expected from a standard capital gain.

Consider a property purchased for $300,000 and sold for $400,000. If the owner claimed $50,000 in depreciation deductions, their adjusted basis would be $250,000. The total gain on the sale is $150,000 ($400,000 sale price – $250,000 adjusted basis). Of this total gain, the first $50,000 is subject to depreciation recapture and taxed at the 25% rate, while the remaining $100,000 is treated as a long-term capital gain.