Investment Property Depreciation Schedule: How to Calculate

Depreciation is a non-cash tax deduction that allows real estate investors to recover the cost of an income-producing property over a set period. This accounting method acknowledges the wear and tear of a building. For investors, it is a tax benefit because it reduces taxable rental income without affecting cash flow.

Determining the Depreciable Basis of Your Property

An investor must first establish the property’s depreciable basis. The calculation begins with the property’s cost basis, which is its purchase price. Added to this are various settlement fees and closing costs paid by the buyer, including:

• Legal fees
• Recording costs
• Transfer taxes
• Title insurance

Land is not depreciable because it does not wear out, so the total cost basis must be allocated between the physical building and the land it sits on. A common method for this allocation is to use the ratio of land-to-building value from a local property tax assessor’s statement. For instance, if an assessor values the land at 20% of the total property value and the building at 80%, this ratio can be applied to the property’s total cost.

If an investor buys a property for $500,000, including closing costs, and the tax assessment indicates an 80% value for the building, the initial basis for the structure would be $400,000. Any major improvements completed before the property is made available for rent, known as being “placed in service,” are also added to this amount. If the investor spent $50,000 on a new roof before the first tenant moved in, the final depreciable basis would become $450,000.

Calculating Annual Depreciation Expense

The Internal Revenue Service (IRS) mandates the use of the Modified Accelerated Cost Recovery System (MACRS) for residential rental properties placed in service after 1986. Under MACRS, investors use the General Depreciation System (GDS), which employs a straight-line method for this type of asset. This means the depreciation expense is spread evenly over the property’s recovery period.

The recovery period for residential rental property is 27.5 years. The depreciation calculation begins on the “placed-in-service” date, which is the day the property is ready and available to be rented, not necessarily when a tenant occupies it. This distinction affects the first year’s depreciation deduction.

The mid-month convention applies to residential rental property, treating the property as being placed in service in the middle of the month, regardless of the actual date. For a full year of service, the annual depreciation is calculated by dividing the depreciable basis by 27.5. For a $450,000 depreciable basis, the full annual deduction would be $16,364. If that property were placed in service on March 20th, the first year’s depreciation would be for 9.5 months (from mid-March through December), resulting in a deduction of $12,957. For the next 26 years, the owner would claim the full $16,364, with a final partial deduction in the 28th year.

Reporting Depreciation and Accounting for Capital Improvements

The annual depreciation amount is calculated and reported on IRS Form 4562, “Depreciation and Amortization,” which records the asset’s basis, placed-in-service date, and depreciation method. This total deduction then flows to Schedule E, “Supplemental Income and Loss.” The depreciation expense is listed on Schedule E alongside other operational costs like mortgage interest and property taxes, directly lowering the net taxable income from the property.

Investors must distinguish between a repair and a capital improvement made after a property is in service. A repair, such as fixing a leaky faucet, is a current expense that can be fully deducted in the year it occurs. A capital improvement, such as replacing the entire plumbing system, adds substantial value or prolongs the life of the property and must be depreciated separately.

This new capital improvement is treated as a distinct asset with its own basis and depreciation schedule. For a residential rental property, this new asset is also depreciated over 27.5 years, starting from the date the improvement was placed in service. This means an investor might have multiple depreciation schedules running concurrently for a single property.

Understanding Depreciation Recapture Upon Sale

When an investment property is sold, the tax benefits of depreciation are subject to a rule known as depreciation recapture. The IRS requires investors to pay taxes on the total depreciation deductions claimed over the life of the investment. The recapture rule is the mechanism for the government to recover a portion of that benefit.

The amount subject to recapture is the lesser of either the total gain on the sale or the total accumulated depreciation taken. For example, if a property was purchased for $400,000, sold for $600,000 (a $200,000 gain), and the owner had claimed $150,000 in depreciation, the entire $150,000 would be recaptured. If the gain was only $100,000, then only $100,000 would be recaptured.

Recaptured depreciation, known as “unrecaptured Section 1250 gain,” is taxed at the investor’s ordinary income tax rate, with a maximum rate of 25%. This is higher than the long-term capital gains rates of 0%, 15%, or 20%. Any gain from the sale that exceeds the recaptured depreciation is taxed at these lower long-term capital gains rates.

For a sale with a $200,000 total gain and $150,000 of recaptured depreciation, the tax would be structured in two parts. The $150,000 is taxed at a maximum of 25%, while the remaining $50,000 is taxed at the lower long-term capital gains rate.