What Happens After 27.5 Years of Depreciation on a Rental Property?

Rental property owners use depreciation to reduce taxable income, spreading a building’s cost over 27.5 years for residential properties. This tax benefit offsets rental income but eventually runs out once the full depreciation period is completed. At that point, owners must consider tax implications, investment strategies, and reporting requirements.

Completion of Depreciation Schedule

After 27.5 years, a property is fully depreciated for tax purposes, meaning no further deductions can be claimed under the Modified Accelerated Cost Recovery System (MACRS). Without this deduction, taxable income from the property may rise if no other offsets are available.

Even though depreciation deductions stop, rental income continues, and expenses such as maintenance, property taxes, and insurance remain deductible. Some investors conduct cost segregation studies to identify components like appliances or flooring that may still be depreciable under shorter recovery periods.

Major renovations or capital improvements can be depreciated separately under a new schedule. For example, replacing a roof or upgrading an HVAC system is typically depreciated over 27.5 years for residential properties or 39 years for commercial properties. The Tax Cuts and Jobs Act (TCJA) introduced bonus depreciation for certain qualified improvements, though this provision is being phased out.

Depreciation Recapture Tax

When a rental property is sold after years of depreciation deductions, the IRS requires landlords to account for the tax benefits they received. Depreciation recapture taxes the portion of the property’s gain attributed to depreciation at a maximum rate of 25%, rather than the lower long-term capital gains rate.

For example, if a property was purchased for $300,000 and $150,000 in depreciation was claimed, the adjusted cost basis would be $150,000. If the property sells for $400,000, the taxable gain is $250,000 ($400,000 sale price – $150,000 adjusted basis). Of this, $150,000 is subject to recapture tax, while the remaining $100,000 is taxed at the long-term capital gains rate, which varies based on the seller’s taxable income.

Depreciation recapture applies regardless of whether the property appreciated or declined in value. Even if the sale price is close to or below the original purchase price, taxes may still be owed. Some investors use a 1031 exchange to defer these taxes by reinvesting proceeds into another like-kind property, though strict IRS rules govern eligibility and timing.

Adjusted Basis and Subsequent Changes

The adjusted basis of a rental property changes over time due to depreciation and capital improvements. Depreciation lowers the basis, while certain expenditures increase it, affecting taxable gain or loss upon sale. Capital improvements, such as adding a new room or upgrading electrical systems, raise the adjusted basis since they enhance the property’s value or extend its useful life. These expenditures must be capitalized and depreciated over time.

Legal fees, title insurance, and recording costs associated with acquiring or improving the property also increase the basis. If an owner refinances, loan-related fees, such as points paid to reduce interest rates, do not directly impact the basis but can affect tax deductions over time. Casualty losses from events like fires or natural disasters may reduce the adjusted basis if insurance proceeds do not fully cover the damages. If an insurance settlement exceeds repair costs, the excess may be taxable.

Options for Holding or Selling

Once a rental property is fully depreciated, owners must decide whether to retain or sell it. Holding onto the property provides continued rental income, but without depreciation deductions, taxable income may increase. Investors may explore alternative tax strategies, such as reallocating expenses or using passive activity loss rules under IRS regulations to offset gains with other real estate losses.

Selling the property introduces capital gains tax considerations, and the timing of the sale can affect net proceeds. If an owner expects to be in a lower tax bracket in retirement, deferring the sale could reduce tax liability. Installment sales allow sellers to spread out gains over multiple years, reducing the impact of a large one-time tax event.

Reporting Requirements

After the 27.5-year depreciation period ends, rental property owners must comply with tax reporting obligations, particularly if they sell the property. The IRS requires accurate documentation of depreciation claimed over the years, as this affects the adjusted basis and tax liabilities. Failing to track depreciation properly can lead to miscalculations and unexpected tax bills.

If the property is sold, the transaction must be reported on IRS Form 4797 (Sales of Business Property), detailing the original purchase price, accumulated depreciation, and final sale amount. Depreciation recapture is categorized separately from capital gains and taxed accordingly. Owners who continue holding the property must report rental income on Schedule E (Supplemental Income and Loss), and any new capital improvements should be documented for future depreciation eligibility. Proper record-keeping ensures compliance and helps owners make informed financial decisions.