What Is House Depreciation and How Does It Work?

House depreciation is a tax deduction for real estate investors, allowing them to recover the cost of an income-producing property over a set period. It accounts for the gradual wear and tear, deterioration, or obsolescence of the physical structure. This deduction is a non-cash expense, meaning it reduces your taxable income without requiring an actual cash payment.

Qualifying Properties for Depreciation

For a property to be eligible for depreciation, the Internal Revenue Service (IRS) outlines four conditions. First, you must be the legal owner of the property. Second, the property must be used in a business or other income-producing activity, such as being rented out to tenants. This is a distinction that disqualifies your primary personal residence from being depreciated.

The property must also have a determinable useful life, meaning it will eventually wear out or lose value. Finally, it must be expected to last for more than one year. Residential rental property is defined as a building where at least 80% of the gross rental income comes from dwelling units, which excludes transient housing like hotels.

Establishing the Depreciable Basis

Before calculating any deduction, you must first establish the property’s depreciable basis. The initial cost basis is determined by taking the purchase price and adding certain settlement fees and closing costs you paid. These can include expenses like legal and recording fees, abstract fees, surveys, transfer taxes, and title insurance.

An important step is to separate the cost of the building from the cost of the land. Land is not depreciable because it is not considered to wear out. A common method for allocating the value is to use the ratio of land-to-building value from the local property tax assessor’s records. For example, if the tax assessment values the building at 70% of the total property value, you would apply that same percentage to your total cost basis to find the depreciable basis of the building.

Any significant capital improvements made to the property, such as a new roof or an HVAC system, are also added to the basis or depreciated separately. These are improvements that increase the property’s value or extend its life, as opposed to simple repairs. This final figure becomes the depreciable basis you will use.

Calculating Annual Depreciation

The standard method for depreciating residential rental properties placed in service after 1986 is the Modified Accelerated Cost Recovery System (MACRS). Under the General Depreciation System (GDS), the IRS has determined the “useful life” or recovery period for a residential rental property to be 27.5 years. This means you will deduct a portion of the property’s basis each year over that timeframe.

The annual depreciation deduction is calculated with a simple formula: the property’s depreciable basis is divided by 27.5 years. For instance, if the depreciable basis of your rental house is $275,000, your annual depreciation deduction would be $10,000. This annual deduction is calculated on Form 4562, Depreciation and Amortization. The total from this form is then reported on Schedule E (Form 1040), Supplemental Income and Loss, to reduce your taxable rental income.

For the first year the property is placed in service, the IRS uses a “mid-month convention.” This rule treats the property as being placed in service in the middle of the month, regardless of the actual date it became available for rent. As a result, the first year’s deduction is prorated based on how many months it was in service.

Depreciation Recapture Upon Sale

When you sell a rental property, the tax benefits received from depreciation are subject to recapture. The IRS requires you to account for the total depreciation deductions you claimed (or were entitled to claim) over the years of ownership. This process, known as depreciation recapture, treats the portion of your gain attributable to depreciation differently from the rest of your gain.

The portion of your gain attributable to the depreciation you claimed on the building is taxed at a maximum rate of 25%. This rate can be higher than the long-term capital gains tax rates, which are typically 0%, 15%, or 20% depending on your income. If you also depreciated personal property within the rental, such as appliances or carpeting, the depreciation recaptured from those items is taxed at your regular ordinary income rate. Any remaining gain on the sale, above and beyond all recaptured depreciation, is treated as a standard capital gain.

Depreciation is a tax deferral mechanism, not a permanent tax elimination. The details are reported on Form 4797, Sales of Business Property.