Depreciation is one of the biggest benefits of owning a rental property, along with the potential for recurring income and appreciation in property value over the long term.
But while income and equity can increase a tax burden, depreciation expense helps to decrease or even eliminate taxes owed on the income a rental property generates.
In fact, it’s possible for an investor to own a rental property that’s cash-flow positive while paying nothing in taxes.
- Depreciation is a non-cash expense rental property owners take to reduce the amount of taxable net income.
- Residential rental property is depreciated over a period of 27.5 years.
- Real estate investors can depreciate the value of the building and certain improvements, but not the value of the land.
- When a rental property is sold, any depreciation expense taken is recaptured and taxed at the investor’s normal tax rate, up to a maximum of 25%.
- Investors often conduct a 1031 tax deferred exchange to defer paying tax on depreciation recapture and capital gains.
How Depreciation Works
Residential rental property owned for business or investment purposes can be depreciated over 27.5 years, according to IRS Publication 527, Residential Rental Property.
Depreciation is based on the concept of an asset having a “useful life.” Depreciation expense is meant to compensate a rental property owner for normal wear and tear to the building over a period of time. Land value is exempt from depreciation, because land never wears out or is used up.
To calculate depreciation, the value of the building is divided by 27.5 years. The resulting depreciation expense is deducted from the pre-tax net income generated by the property. The income remaining after deducting the depreciation expense is passed through to the owner, and taxes are paid based on the owner’s federal income tax bracket.
Of course, most rental property doesn’t completely wear out and become unusable in less than 30 years. There are plenty of homes that were built 50, 75, or even 100 years ago that are still used as rental properties today. Over the years, they’ve been maintained to attract good tenants and to continue generating income for the owner.
Rental property depreciation continues during the holding period of the property, and resets to another 27.5 years for a new owner when the property is sold. If an owner holds the property for more than 27.5 years the depreciation expense runs out because the building’s useful life has expired, at least for the purposes of rental property depreciation.
Rental Property Depreciation Methods
A property must qualify for depreciation before an investor can claim a rental property depreciation expense. There are several criteria a real estate investor must meet in order to depreciate rental property:
- Investor must be the owner of the rental property and not a tenant.
- Property must be used for business or investment purposes, such as renting the home to a tenant.
- Useful life of the property must be able to be determined, which is why land value is not depreciated.
- If a property isn’t held for at least one year, the investor is not eligible to claim the depreciation expense.
There are three different ways to depreciate residential rental property. All three rental property depreciation methods refer to when the property is “placed in service” which means when the property is ready and available for rent.
- Rental property placed in service before 1981 can be depreciated using the straight line or declining balance method.
- Property placed into service after 1980 but before 1987 uses the Accelerated Cost Recovery System (ACRS) for depreciation.
- Rental property placed into service after 1986 generally uses the Modified Accelerated Cost Recovery System (MACRS). However, under MACRS, rental property owners are allowed to use the Alternative Depreciation System (ADS) for most property, which is another name for the straight line method of depreciation.
Accurately calculating rental property depreciation can obviously be complicated. That’s why many real estate investors pay a tax professional or sign up for a free account with Stessa to accurately track the depreciation expense of a rental property.
In addition to automatically tracking rental property depreciation, Stessa’s new rental property balance sheet simultaneously updates each property to market value (versus depreciated value) to give real estate investors a more accurate idea of property equity.
How to Calculate Depreciation on Rental Property
Now let’s take a look at a simplified example of how to calculate rental property depreciation using the straight line method of depreciation.
A single-family home in Austin, Texas was purchased by a real estate investor and was placed into service as a rental property on January 1, 2017. According to Zillow, the home value was $391,000. During a four year holding period, the home appreciated in value to $521,000. The investor decides to sell and the transaction closes on December 31, 2020, just in time for the new year.
- Determine Rental Property Cost Basis
Before the investor can calculate rental property depreciation, the cost basis of the home needs to be determined. Cost basis is the value of the home minus the value of the land the home sits on, plus any closing costs that must be depreciated including:
- Property survey
- Title insurance
- Recording fees
- Abstract fees
- Legal fees
- Transfer taxes
There are other costs that must be depreciated that aren’t normally seen in most residential real estate transactions, such as property taxes owed by the seller that the buyer assumed, the seller’s real estate commission owed to an agent, or the cost of installing utilities.
We’ll assume that the real estate investor incurred closing costs of $3,000 when the property was first purchased, which must be added to the cost basis and depreciated. In addition, according to the county assessor and appraisal report, the value of the lot was $25,000 when the home was purchased back in January 2017.
Based on this information, the investor can calculate the cost basis of the home:
- Purchase price = $391,000
- Less lot value = <$25,000>
- Plus closing costs qualified for depreciation = $3,000
- Cost basis = $369,000
- Calculate Rental Property Depreciation Expense
To calculate the annual rental property depreciation expense, the cost basis of the property is divided by 27.5 years:
- $369,000 property cost basis / 27.5 years = $13,418.18 annual depreciation expense
So, over the four-year holding period, the investor was able to claim a depreciation expense of $53,672.72 to reduce the amount of taxable net income.
Hypothetically, if the rental home generated a total pre-tax net income of $60,000 over the four year period, the investor would only pay taxes on $6,372.28 thanks to the rental property depreciation expense:
- $60,000 pre-tax income – $53,672.72 depreciation expense = $6,372.28 taxable income
How to Calculate Depreciation by Month
A real estate investor can claim a depreciation expense of 3.636% of the investment property value each year. However, in the real world, rental property isn’t normally purchased and sold on the first day of the year and the last day of the year.
To help make calculating depreciation easier, the IRS provides real estate investors with a table to help determine the depreciation percentage to claim based on the month the rental property was placed in service:
|Month Placed Into Service||
Costs Basis Depreciation Percentage
For example, if a rental property with a cost basis of $100,000 was first placed in service in June, the depreciation for the year would be $1,970:
- $100,000 cost basis x 1.970% = $1,970
In each of the following years, the depreciation expense would be $3,636.36:
- $100,000 x 3.636% = $3,636.36
Rental Property Items with Faster Depreciation
In addition to depreciating the building, real estate investors can also depreciate items placed into service in a rental property faster than 27.5 years:
5-year depreciation: Appliances, carpeting, furniture
7-year depreciation: Office furniture and equipment
15-year depreciation: Roads and fences
For example, let’s assume an investor spends $8,000 on new carpeting and rebuilds a wooden backyard fence at a cost of $15,000. The extra depreciation expense would be:
- Carpeting: $8,000 / 5 years = $1,600 carpet depreciation per year.
- Fence: $15,000 / 15 years = $1,000.
How to Recapture Rental Property Depreciation
Depreciation expense is a tax benefit of owning rental property. However, when the property is sold, the depreciation expense taken is “recaptured” by the IRS and taxed as regular income.
To illustrate, let’s use our real estate investor in Austin as an example.
During the four-year holding period, the investor claimed a total depreciation expense of $53,672.72 to reduce the amount of taxable income. When the property is sold, the investor is required to pay tax on the $53,672.72 up to a maximum rate of 25%, even if the investor is in a higher federal tax bracket.
The maximum amount of tax owed from depreciation recapture would be $13,418.18, with any remaining capital gain taxed at 0%, 15%, or 20% depending on the investor’s tax bracket.
Instead of paying tax on depreciation recapture and capital gains, many real estate investors conduct a 1031 tax deferred exchange. Rather than paying taxes to the federal and state governments, investors use that extra cash to purchase another rental property to grow their real estate portfolio.
Final Thoughts on This Topic
Rental property depreciation can save real estate investors a significant amount of money in taxes. In fact, when a property is first purchased, depreciation expense can completely eliminate any tax due on income because cash flow is lower due to repairs and the costs of finding a new tenant.
When a rental property is sold, any depreciation expense is recaptured and taxed at the investor’s normal income tax rate, up to a maximum of 25%. To defer paying taxes on depreciation recapture and capital gains, many investors choose to conduct a 1031 exchange and use the money saved to purchase more real estate instead of paying the government.