Understanding Real Estate Depreciation 

If you’ve ever filed real estate taxes, you’ve doubtlessly heard the term “depreciation.” Depreciation refers to the loss of value of an asset over time. Electronics, cars, real property, and other assets lose value, or depreciate, as they age. 

Because your real estate gradually loses value, the Internal Revenue Service (IRS) allows (and requires) property owners to take yearly depreciation deductions on their qualifying property. This means that over a property’s useful life, you must deduct a portion of its value from your taxable rental income on your tax return. 

Depreciable assets like real property must be carefully documented so that you take the correct deduction amount each year of its use. Continue reading to learn more about how this process works, and download Innago’s real estate depreciation spreadsheet (above) to help you track deductions for each year of your rental property’s IRS recovery period. 

What is Real Estate Depreciation? 

As mentioned above, real estate depreciation refers to scheduled deductions taken on long-term real property to reflect their gradual decline in value. 

Annual depreciation might seem counter-intuitive at first glance. The savvy investor will know that most real estate tends to appreciate over time, even if the property suffers typical wear-and-tear. However, rental property depreciation applies even if your property increases in value over time. 

Qualifications 

As you know, residential real estate is subject to depreciation. But what else qualifies? Below are the IRS’s four criteria for depreciation: 

1. Long-term property. The property must last longer than one year and be part of your capital investment. Buildings, cars, appliances, and equipment are all depreciable. 
2. Subject to wear and tear. The property must have a finite usable lifespan. 
3. One year minimum ownership. For real estate, the property must be in your name for at least one year. 
4. Rental business use. The property must be used for your rental business, not personal. 

How Does Depreciation Work? 

Depreciation deductions allow you to deduct a portion of your property’s value from your taxable income over each year of its useful lifespan. A property’s useful lifespan is also called its recovery period, and it is determined by the IRS. In order to depreciate residential rental property, for instance, you’d need to know that that asset class’s recovery period is 27.5 years. 

Below are the IRS recovery periods for a few common types of property: 

Type of Property	Recovery Period
Residential real property	27.5 years
Commercial real property	39 years
Non-building permanent structures (e.g., fences, sidewalks)	15 years
Manufactured homes	10 years
Computers, equipment, and furniture	5 years
Automobiles	3 years

 

Recovery periods begin when the property is placed in service (installed or ready to rent) and end when you fully recover its value, retire it, or sell it. The whole process starts over with each new owner whenever the property is bought or sold. 

Like any deduction, depreciation deductions reduce your tax bill in the time that you own the property. This is great news for investors—it means you’ll pay less in taxes and save more money to reinvest in your business.  

However, it’s important to note that depreciation is only a delay in taxes—not an elimination of them. Because property values typically do increase over time, the IRS looks to “recapture” the taxes you avoided paying when you sell the property later. This is called depreciation recapture, and it refers to when the IRS taxes the amount of your sales profit attributable to depreciation deductions. Although there are ways to delay this process further (like 1031 “like-kind” exchanges), it’s important to remember this before selling your property. 

How to Calculate Real Estate Depreciation? 

Now that you understand the basics of depreciation, you may be wondering how to calculate real estate depreciation for your investment property. There are a few different methods. Each of them requires that you know two things: 

1. The cost basis of your property, or its value for tax purposes. For real estate, the cost basis is generally determined by taking the property’s purchase price, adding certain other expenses, and subtracting the cost of land (which is not a depreciating asset). 
2. The recovery period for that specific type of property (commercial or residential rental property). 

Once you know these two numbers, you can move on to deciding which depreciation method applies. You’ll need to know which method is the correct one to use even if you’re just interested in getting a rough estimate using a real estate depreciation calculator or spreadsheet. 

Modified Accelerated Cost Recovery System 

The overall system used in the U.S. for tax depreciation is the Modified Accelerated Cost Recovery System (MACRS). It includes various methods to recover the cost of assets over time, primarily for tax purposes. 

MACRS is most associated with accelerated depreciation, which front-loads depreciation expenses to the earlier years of the asset’s life (e.g., declining balance methods). However, for certain types of assets (like residential and nonresidential real property), MACRS prescribes a different method to calculate depreciation called straight-line depreciation. This is because a more even expense distribution over the asset’s useful life is often more appropriate for these types of property. 

We’ll look at each of these methods in more detail in the next sections. The idea is that under MACRS, taxpayers might use either method depending on the property type and circumstances. Keep in mind that there are specific rules as for when you can elect to use each method, so we recommend reading the IRS rules yourself or reviewing them with a real estate tax professional if you have questions.

Straight-Line Depreciation

Straight-line depreciation is the simplest method of depreciation. Using the straight-line method, equal amounts of the cost basis are deducted each year except for the first and last, which vary based on the month the property was placed in service. For example, if you’re depreciating a residential property using the straight-line method, the deductions would amount to about 1/27.5 of the cost basis each year.

Accelerated Depreciation

In some cases, MACRS allows for faster depreciation of a property in the first few years it is in service, with slower depreciation in later years. MACRS depreciation includes the general depreciation system (GDS) and the alternative depreciation system (ADS), each with different recovery periods and methods. 

Accelerated depreciation real estate benefits include the ability to take larger depreciation deductions up front, which saves you money and gives you more capital earlier on to reinvest in your business. The GDS is best for assets with short recovery periods, like computers and equipment. It’s best to talk with a tax advisor knowledgable about depreciation deduction to determine whether the alternative depreciation system or general depreciation system applies. 

Tax Implications 

It’s usually beneficial for investors to take as many tax deductions as they qualify for. This will allow you to free up as much cash as possible to reinvest in your business and grow it earlier rather than later, maximizing returns. 

Tax strategies like cost segregation can help you save even more money, by taking advantage of shorter recovery periods when possible (e.g., separating a swimming pool from the rental property you bought it with). 

In some cases, it may be possible to deduct the cost of certain depreciable personal property all at once, in the first year of ownership (like you would deduct the cost of a repair or operating expense) rather than depreciating it over time. If you can do this, you should – you will free up even more money and eliminate concerns about recapture down the line. 

For example, bonus depreciation is used for personal property and usually automatically applied. Likewise, the De Minimis Safe Harbor allows you to fully deduct any property less than the $2,500 cap. Section 179 expensing also allows single-year deductions under specific rules to follow. 

Most of these exceptions apply to lower-cost personal or business property related to your rental business, but you should look for all ways to save money on your taxes. 

Conclusion 

Understanding real estate depreciation can be a daunting endeavor. It’s highly complex, and the rules often change over time. Innago’s real estate depreciation worksheet is a great way to get started understanding the depreciation basics and fundamentals you’ll need to know to file your return correctly come tax season. However, you should also seek advice from a tax advisor who can answer common rental property depreciation FAQs and offer further guidance on how to claim depreciation deductions.