How to Depreciate a House for Rental or Investment Purposes

Depreciation allows rental property owners to recover their investment cost over time by deducting a portion each year. This tax benefit reduces taxable income, making it a key consideration for real estate investors. However, depreciation rules are complex, and mistakes can lead to IRS penalties or unexpected tax liabilities when selling the property.

Understanding how to calculate and apply depreciation correctly ensures compliance with tax regulations while maximizing financial benefits.

Determining Cost Basis

Establishing the cost basis of a rental property is the first step in calculating depreciation. The cost basis includes the purchase price and certain acquisition costs, such as title fees, legal expenses, recording fees, and transfer taxes. Loan origination fees and prepaid property taxes are excluded since they are either deductible in the year paid or amortized separately.

If the property was inherited, the cost basis is its fair market value on the original owner’s date of death, typically determined through an appraisal or comparable sales data. For gifted properties, the basis is generally the donor’s original cost, though adjustments may be needed if the fair market value at the time of transfer is lower. When converting a personal residence into a rental, the basis is the lower of the original purchase price or fair market value at the time of conversion.

Allocating Value Between Land and Building

Depreciation applies only to the building, not the land. The IRS requires property owners to allocate the purchase price between these two components, which can be challenging due to varying land values.

One method is using the local tax assessment, which often separates land and building values. For example, if a property is assessed at $200,000, with $40,000 allocated to land, then 80% of the purchase price is assigned to the building. However, tax assessments may not reflect market value, so relying solely on them can be inaccurate.

An appraisal is a more precise alternative, as it typically provides a breakdown of land and structure values. If an appraisal is unavailable, comparable sales data can help estimate land value by analyzing similar properties where land and building values are separately reported. Some insurers also provide replacement cost estimates for the structure, which can assist in determining a reasonable allocation.

Selecting a Depreciation Method

The IRS requires residential rental properties to be depreciated using the Modified Accelerated Cost Recovery System (MACRS), which applies a straight-line method over 27.5 years. This means an equal portion of the building’s depreciable value is deducted annually. Commercial properties use a 39-year recovery period.

Depreciation begins when the property is placed in service, meaning when it is available for rent, not when it is purchased. The IRS applies the mid-month convention, so depreciation is prorated based on the month the property is placed in service. For example, if a rental becomes available on September 10, only 3.5 months of depreciation can be claimed for that year.

Some investors use cost segregation studies to accelerate depreciation on certain components, such as appliances, carpeting, or landscaping, which qualify for shorter depreciation periods of 5, 7, or 15 years. While this strategy increases deductions in the early years, it also adds complexity and can lead to higher depreciation recapture taxes upon sale.

Handling Improvements and Renovations

Upgrades to a rental property must be classified as either repairs or capital improvements for tax purposes. Repairs, such as fixing a leaky faucet or patching drywall, can be deducted in the year incurred. Improvements, which enhance, restore, or adapt the property for a new use, must be capitalized and depreciated.

For example, replacing a few broken roof shingles is a repair, while installing a new roof is an improvement depreciated over 27.5 years. The IRS categorizes improvements into betterments (e.g., upgrading from laminate to hardwood flooring), restorations (e.g., rebuilding a collapsed foundation), and adaptations (e.g., converting a garage into a rental unit).

Certain safe harbor rules allow immediate expensing of some costs. The de minimis safe harbor permits deducting items under $2,500 per invoice ($5,000 for businesses with audited financial statements), reducing the need for capitalization.

Tracking Depreciation for Potential Sale Recapture

Depreciation lowers taxable income during ownership but creates tax implications upon sale. The IRS requires investors to recapture the depreciation claimed, taxing it as ordinary income up to a maximum rate of 25%.

Depreciation recapture applies only to the building portion of the property. For example, if a property was purchased for $300,000 with $240,000 allocated to the structure and $60,000 to land, and $50,000 in depreciation was claimed, the adjusted cost basis becomes $250,000. If the property sells for $400,000, the $50,000 in depreciation is subject to recapture at up to 25%, while the remaining gain is taxed as capital gains at 0%, 15%, or 20%, depending on the seller’s income level.

A 1031 exchange allows investors to defer depreciation recapture by reinvesting proceeds into another rental property. To qualify, the replacement property must be of like-kind, and the transaction must meet strict timing rules, including identifying a new property within 45 days and completing the exchange within 180 days. While this strategy postpones taxes, the deferred depreciation carries over to the new property. If the property is held until death, heirs receive a step-up in basis, eliminating the deferred tax liability.