How to Calculate Depreciation
October 5, 2022
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As many investors know, there are three main ways to make money in real estate investing: appreciation, cash flow, and the tax advantages a property affords you. Fundamental to those tax advantages is the concept of depreciation.
If you’re unfamiliar with what depreciation is or why it matters, we’ll summarize it in brief here; however, we recommend that you first check out this article on the topic beforehand – The Basics of Depreciation.
What is Depreciation?
Depreciation is an accounting method that spreads the cost of an asset over its expected useful life. And assets lose value over time.
Depreciation is essentially the recognition that physical things deteriorate and become less valuable over time. The most obvious example is a car. Every mile you put on a car makes it less valuable. Anything you use that takes wear and tear over time diminishes in value. The IRS allows you to reduce your tax bill by accounting for this diminishing value in the form of depreciation.
Uniquely, real estate is one of the few assets that typically appreciates in market value rather than depreciate, but we won’t tell the IRS if you don’t!
Factors that Impact Depreciation
How is rental property depreciation calculated? The formula consists of dividing the cost basis by the property’s useful life. Two main factors impact depreciation:
1) The cost basis of the property, or the amount it’s worth for tax purposes
2) The recovery period determined by the IRS
Before we go any further, let’s quickly define cost basis. The cost basis is the original value of a property when you buy it (including recording and legal fees and seller debts you may be covering). This is important because it provides the starting point for depreciation. For more information on cost basis, read our companion article – What is Cost Basis and Why is it Important?
So, the first piece of information you need is how much you paid for the property. Once you have that figure, you may need to add specific expenses to determine the cost basis—for instance, closing costs you were responsible for and property improvements like a new roof. It’s important to understand that determining the cost basis isn’t an exact science.
After you figure out the cost basis, you need to identify the recovery period. For example, the recovery period for residential real property is 27.5 years. Consult the IRS website if you’re unsure about the recovery period for your property.
Once you have these figures, it’s fairly simple to calculate the amount to depreciate every year. For instance, buildings are depreciated using the straight-line method, which means you deduct equal amounts (1/27 of the basis for residential property) from the cost basis annually, excluding the first and last because they change depending on the month.
If we’re going to talk about depreciation as it relates to real estate, we have to talk about buildings. Why? Because buildings are one of the largest depreciating assets. Buildings consist of the structural components that make up a building, like walls, floors, roofs, windows, and plumbing fixtures. These components are all part of the building for depreciation purposes.
If you rent out a building, then it’s a “residential rental property.” If no one lives in a building, it’s considered a “nonresidential real property.”
To depreciate a building that you use for rental activities, begin depreciation when the building is placed in service. “Placed in service” means the building is ready and available to rent (it doesn’t matter whether it’s occupied or not). You will want documentation that proves when your property was placed in service. In other words, keep copies of rental ads or listings advertising that the property is available to rent.
It’s important to mention that buildings follow an added rule called the mid-month convention. According to this convention, you should treat buildings as being placed in service at the mid-point of the month. Then, when you sell the building, you’ll get a bonus equal to half a month’s depreciation.
Useful Life of Properties
Lastly, it’s important to understand that the IRS standardized what’s known as the useful life of properties. When it comes to rental properties, here’s a general overview of what you need to know:
- Choice of depreciation methods: The General Depreciation System (GDS) and the Alternative Depreciation System (ADS) are your two choices. You might have to use ADS if your property is used for certain business purposes. If not, though, you’ll have a choice between the options. Once you decide on your system, you must use it for as long as you claim depreciation on said property. ADS typically has longer life cycles than GDS, but GDS allows you to claim higher levels of depreciation year to year.
- Residential rental property: The useful life of residential rental property when using GDS is 27.5 years. It’s 30 years under ADS.
- Land: Land cannot be depreciated because it doesn’t experience wear and tear like buildings.
Depreciation can be quite complex. It’s important to understand how to figure it out. You want to ensure you come up with reasonable numbers that the IRS will allow.
This article provides an excellent starting reference point as you learn more about depreciation and saving money through taxes.