How To Calculate Rental Property Depreciation – A Definitive Guide

Depreciation might be one of the best benefits of real estate investing. It offsets your rental income to significantly lower your tax liability and lets you keep more of your hard-earned money from your rental property.

The best part about depreciation is it doesn’t affect your cash flow. You don’t pay it, but you do get to write it off on your taxes. It’s almost like free money for real estate investors. In fact, it’s one of the biggest tax deductions in real estate investing. If you’re not convinced, then check out our visual guide to the benefits of real estate depreciation.

Depreciation is just one of the benefits that we love in real estate. Let’s explore how it works and how to accurately calculate depreciation on your rental property.

What Is Depreciation?

In simple terms, depreciation is the decrease in value of an asset over time due to normal wear and tear. From a tax perspective, the IRS allows businesses to deduct the fair value of some assets over their useful life. In contrast, most business expenses are deducted in the year they take place.

For example, if you bought a $1500 laptop for your business, you would not deduct the $1500 from your taxable income in the year you bought it. Instead, the IRS specifies the “useful life” of the laptop to be 5 years. So you would deduct $300 ($1500 / 5) in each of the next 5 years.

Different types of assets have different “useful lives” which are determined by the IRS. Some depreciate over shorter terms (3, 5, or 7 years), and some over longer terms. Residential rental properties depreciate over 27.5 years, and commercial properties depreciate over 39 years.

The IRS issues rules regarding what assets can be depreciated and the method of depreciating the assets. When it comes to real estate investing, the IRS defines the depreciation rules in Publication 527.

What Can Be Depreciated In A Rental Property?

There are 2 categories of depreciable assets for a rental property.

The first is the property itself. The IRS deems buildings as having a “useful life” of 27.5 years for residential properties. Now, there aren’t many residential buildings that are torn down after 27.5 years of service, so this is a huge tax advantage to real estate investors.

The second is any capital expenses that have a useful life of more than 1 year. This includes appliances, roofing, flooring, fencing, etc. IRS Publication 527 provides a list of these depreciable expenses and the useful life (5, 7, or 15 years).

Let’s take a closer look at each of these categories of depreciable assets.

The Structures on the Rental Property

Depreciation of the rental property is one of the biggest tax benefits to real estate investors as it often offsets the net income from the operation of the rental property. This means many real estate investors end up paying zero tax with the help of this deduction.

The IRS allows you to depreciate the building and structures on your rental property. The land is specifically excluded from depreciation because land doesn’t have a “useful life” — it can’t be used up.

To depreciate the fair value of the building, you must satisfy a few requirements for the IRS.

1. You own the property
2. The property is used for an income producing business
3. You own the property for more than 1 year

Assuming you aren’t doing a fix-and-flip, and you purchased the property (even if you have a mortgage), you will satisfy these requirements.

You also get to include certain fees and expenses incurred during the purchase of the property. This includes any abstract fees, title transfer fees, legal fees, surveys, utility installation, recording fees, and title insurance. It does not include any costs associated with obtaining the loan (points, mortgage insurance, or fees for appraisals required by the lender).

Certain Capital Expenses

In addition to depreciation on the rental building, you must depreciate any improvements or expenses that have a useful life of more than one year. Anything that has a useful life of less than one year should instead be deducted as a normal operating expense.

The IRS provides a list of improvements that must be depreciated. This includes some smaller expenses like appliances and landscaping and larger expenses like roofing, flooring, and additions. It also includes some capital expenses needed to operate your rental business such as computers or office equipment.

In general, any maintenance or improvement you make that you don’t expect to do every year may meet the requirement of a useful life greater than one year.

When Does Depreciation Start and End?

We have covered what should be depreciated, but how do we know when to start and end deducting depreciation?

Depreciation of a rental property starts in the month when the asset is put into service and ends in the month when the property is sold, destroyed, converted into personal use, or after fully deducting the 27.5 years of useful life depreciation. “Put into service”, in general, means the date you start offering the property for rent.

For example, let’s say you purchased a property in March. You then spent 2 months renovating the property and listed it for rent in May. You would start deducting the depreciation in May.

The start of depreciation for other capital purchases is a little more complicated. Depending on when in the year you made the purchase, you will either start depreciation in the half-year or the quarter that the asset was purchased. We will cover this in more detail later.

How Depreciation Impacts Your Taxable Income

Depreciation is treated as a tax deduction similar to operating expenses. The difference is that you don’t pay any of the depreciation (technically you do, but only after the property is sold through depreciation recapture).

Because it is a tax deduction, depreciation is subtracted from the income from your rental property. For example, if you had a net income of $6,000 from your rental operation and you have $5000 of depreciation, your net taxable income is only $1000.

In many cases, and particularly in the first few years, this deduction can fully offset the net income from your rental property. And in some cases, the depreciation can reduce your taxable income to less than zero. You may even be able to deduct this from the income you make from other sources. However, the IRS has limits on how much you may be able to deduct. Nolo has a good resource on tax-loss limits if you want more information.

How To Calculate Depreciation Of A Rental Property

Now that we covered the basics of depreciation, let’s take a look at how to calculate it.

Before we do that, however, we need to understand the different methods of calculating depreciation. The rules have changed over the years, but the most recent change was in 1987 so we’ll focus on the current MACRS (Modified Accelerated Cost Recovery System) depreciation system.

Deprecation Methods

The IRS uses 2 basic methods for determining depreciation in the GDS (General Depreciation System) of the MACRS system. This is the most commonly used depreciation system, though an Alternative Depreciation System (ADS) may also be used. We won’t cover the ADS in this article.

The first method is straight-line depreciation. It is used for depreciating the property (buildings and other structures) and any improvements to the structures (roof, HVAC systems, additions, etc). Using this method, you take the same amount of depreciation every year except for the first and last years.

The second method is declining balance and is used for any assets depreciated over 5, 7, or 15 years. This covers everything except for the structures on the rental property. Under this system, a MACRS percentage table is used to determine the depreciation in each year. This method accelerates the depreciation in that a larger deduction is taken in the first years.

With that explanation out of the way, let’s get to the calculations.

Calculating Depreciation of Rental Property

The first type of depreciation is on the property buildings and structures. You calculate this every year starting in the year you bought the property. Every year has the same amount of depreciation except for the first and last years.

The following process describes how to calculate the depreciation of the rental property based on the purchase of the property. You should follow the same process for any improvements that fall into the 27.5-year depreciation schedule (roofs, structural improvements, etc). The difference is that steps 2-5 don’t apply. Instead, you should include any costs associated with the improvement in the cost basis.

Special Considerations For The First And Last Years

As mentioned in the previous section, the first and last years of depreciation only take a portion of the yearly depreciation. The IRS provides a table to help you determine how much depreciation you should take based on the month the property was placed in service.

When you retire the property from service, or at the end of the 27.5 years of depreciation, the percentages are reversed. The table below shows the IRS percentages for your convenience.

Calculating Depreciation of Other Rental Property Assets

Unlike the buildings on your rental property, the other assets (appliances, landscaping, etc) don’t follow a straight-line depreciation method. Instead, they use a declining balance method. You are allowed to take more depreciation in the first few years which then tapers off as the asset ages.

A second caveat to depreciating these assets is that you must either use a mid-quarter or mid-year method depending on when the assets were purchased throughout the year and how much they cost. By default, you use the mid-year method unless you purchased a large chunk of these assets in the last 3 months of the year. In that case, you must use the mid-quarter method. Keep in mind that whatever method you start using for each asset, you must continue to use through the life of the depreciation. This decision is in aggregate, so it looks at the cost of all of the assets placed into service throughout the year.

If 40% or more of the purchases of depreciable assets occur in the last 3 months of the year, then the IRS requires you to use the mid-quarter method. For example, if you purchased a stove in April for $400 and a refrigerator in November for $600, then 60% ($600 / $1000) of the assets went into service in the last quarter of the year. In this case, both the stove and the refrigerator must use the mid-quarter method.

If you instead purchased the refrigerator in August, then none of the assets went into service in the last quarter. Both the refrigerator and stove will then use the mid-year method.

Once you have determined the method to use, you simply look up the yearly depreciation in the table provided in IRS Publication 527. Multiply this percentage by the cost basis of the asset to get the depreciation amount.

Conclusion

Depreciation provides a huge tax benefit to real estate investors. It can significantly reduce or eliminate your tax liability. It can also offset rental income in future years. And you get to enjoy this benefit for many years.

Calculating depreciation has a few nuances but isn’t overly complicated otherwise. If you find yourself overwhelmed, you can always hire an accountant.

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