IRS Publication 527: Depreciation for Rental Property

Depreciation is an annual income tax deduction that allows you to recover the cost of your residential rental property over time. It accounts for the building’s wear and tear, deterioration, or obsolescence, reducing your taxable rental income without being a direct cash expense. The Internal Revenue Service (IRS) provides detailed guidance for property owners in Publication 527, “Residential Rental Property.” This document outlines the rules for reporting rental income and deducting expenses, including how to allocate the costs of a property over its useful life.

Determining Your Property’s Basis for Depreciation

Before calculating depreciation, you must establish the property’s basis, which is the starting figure for the calculation. The initial basis is your cost for the property, including the contract price and settlement fees like legal fees, surveys, transfer taxes, and title insurance.

A property’s basis can change, resulting in an “adjusted basis.” Your basis increases with the cost of additions or improvements with a useful life of more than one year, such as extending utility lines to the property. Conversely, basis decreases from events like receiving an insurance payment for a casualty loss.

A foundational rule is that land is not depreciable because it does not wear out or become obsolete. You must allocate the property’s total cost between the land and the building. Only the cost allocated to the building is depreciable.

An acceptable allocation method is to use the assessed values from your local property tax assessor. For instance, if an assessment values the building at $160,000 and the land at $40,000, then 80% of the value is for the building. You can apply this percentage to your total purchase cost to find the depreciable basis. If you paid $250,000, your depreciable basis for the building would be $200,000 (80% of $250,000).

Calculating Depreciation with MACRS

For residential rental property placed in service after 1986, the IRS requires using the Modified Accelerated Cost Recovery System (MACRS) to calculate depreciation. Most rental owners use the General Depreciation System (GDS), a component of MACRS. GDS for residential rental properties is defined by three elements.

The first element is the recovery period. For residential rental properties, the GDS recovery period is 27.5 years, which is the timeframe for spreading out the building’s cost basis. This period reflects the property’s “useful life” as determined by the IRS.

The second element is the convention. Residential rental properties must use the mid-month convention, which treats the property as placed in service in the middle of the month it was made available for rent. This affects your first-year and final-year depreciation calculations, as you will not get a full year’s deduction in the year of acquisition or disposition.

The final element is the depreciation rate, found in percentage tables in IRS Publication 946, “How To Depreciate Property.” Using a $200,000 depreciable basis placed in service in June, you would find the specific percentage for the 6th month in the 27.5-year GDS table for the first year. For every subsequent full year, you would use the annual rate of 3.636% ($200,000 0.03636 = $7,272).

Distinguishing Between Improvements and Repairs

The costs for repairs and improvements are treated differently for tax purposes. A repair keeps your property in good operating condition but does not add to its value or prolong its life. Repair costs are currently deductible, meaning you can write off the entire expense in the tax year it is paid.

An improvement, however, must be capitalized. This means its cost is added to your property’s basis and depreciated over time, not deducted in a single year. The IRS uses the “BAR” test to classify these expenses. An expense is an improvement if it results in a Betterment, an Adaptation, or a Restoration of the property.

Betterments fix a material defect or add to the property’s value. Restorations involve replacing a substantial structural part or rebuilding it to a like-new condition. Adaptations are costs to change a property’s use, such as converting a basement into a rentable apartment.

For example, fixing a few shingles is a repair, but replacing the entire roof is an improvement. Fixing a leaky faucet is a repair, while replacing all plumbing is an improvement. Accurate records separating these costs are necessary for proper tax reporting.

Depreciating Property Improvements

Each capital improvement is treated as a distinct asset for tax purposes, separate from the main building. The improvement will have its own basis, which is its cost, and its own placed-in-service date. The placed-in-service date is when the improvement is complete and ready for use.

Improvements are also depreciated using the MACRS framework. For improvements to a residential rental property, the recovery period is the same as the property itself: 27.5 years under GDS. This applies to enhancements like a new roof or a kitchen remodel. Other improvements, like new appliances or fences, may have shorter recovery periods of 5 to 15 years.

For example, a landlord adds a new deck costing $10,000, completed on August 10th. The deck’s depreciation begins in August of that year. The $10,000 cost is the deck’s basis, and it will be depreciated over a 27.5-year recovery period using the mid-month convention.

This means the landlord will have separate depreciation calculations for the original building and for each subsequent capital improvement. Every new improvement is added to the depreciation schedule and depreciated independently over its designated recovery period.

Reporting Depreciation on Form 4562

Depreciation is reported to the IRS on Form 4562, “Depreciation and Amortization.” To complete the form, you will need a description of the property, the date it was placed in service, its basis, and the depreciation deduction for the year. The current version of Form 4562 is available on the IRS website.

The primary section for a residential rental building is Part III, “MACRS Depreciation.” A property placed in service during the current tax year is entered on line 19h. You will input the basis, placed-in-service date, recovery period (27.5), convention (MM), depreciation method (S/L), and the deduction amount.

Each improvement is listed on a separate line in this same section. For assets placed in service in previous years, the total depreciation deduction is summarized on line 17. Form 4562 must be attached to your primary federal income tax return, such as Form 1040.

The total depreciation from Form 4562 is then carried over as an expense on Schedule E (Form 1040), “Supplemental Income and Loss.” This deduction is used to offset your rental income for the year.