Rental property depreciation is a process that real estate investors use to deduct the costs associated with purchasing and improving an investment property. Depreciation of rental property happens over the course of the property’s useful life as determined by the IRS’ depreciation method. This is important for investors because rental property depreciation helps maximize tax savings.
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How Residential Rental Property Depreciation Works
Residential rental property depreciation is a capital expense, which means it helps recover the costs you spend to acquire and improve your rental property. Depreciation expense is typically the largest tax deduction available to real estate investors and can help investors improve their cash flow by reducing their tax liabilities. This means every year you can reduce your taxable income without negatively impacting your cash flow.
The standard method of depreciation in the United States is called the modified accelerated cost recovery system (MACRS). Under this system, the capitalized cost basis of property is recovered over a specified life by annual deductions for depreciation. There are two types of MACRS: general depreciation system (GDS) and alternative depreciation system (ADS). Throughout the article, we use GDS because it’s the most common system, and ADS is less common.
Rental property depreciation is calculated over 27.5 years for residential property and 39 years for commercial property. These are the useful lives that the IRS deems for both types of properties. Keep in mind, real estate depreciation begins when the property is placed in service, meaning when you rent it out, not when you purchase it. Depreciation ends when you sell the property or take it out of service, such as if you decide to use it as your primary residence.
Depreciation of rental property covers major repairs that are capitalized, but you can’t use it to offset the cost of rental property normal wear and tear. It only covers purchases and improvements, and there’s often a fine line between what is considered an improvement and what is considered a repair. It’s best to consult with your tax advisor about whether something is an improvement or a repair.
For example, if you repair a few shingles on your roof, that’s considered a repair and is not depreciated. So, instead of depreciating the cost of the repairs, you can expense the full cost of the repair. In contrast, if you need to replace the entire roof, you would depreciate it over the useful life of the roof, which is 27.5 years, the same as the property to which its attached, determined by the IRS’ depreciation schedule because replacing the roof is not a repair but is considered an improvement.
When calculating rental property depreciation, the useful life of common assets are:
- Appliances, carpeting & furniture: 5 years
- Office furniture & equipment: 7 years
- Fences & roads: 15 years
- Residential rental buildings, structures, furnaces & water pipes: 27.5 years
- Commercial buildings: 39 years
What Properties Are Depreciable?
The IRS determines what types of properties you can claim depreciation on. For instance, land, landscaping and a primary residence are not depreciable. In order for real estate depreciation to be applicable, you can’t place a property in service and sell it the same year you depreciate it. This means that you can’t rent out a property in January, sell it in April and claim depreciation on it that same year.
Properties that fall into at least one of the following categories are typically depreciable:
- A rental property placed in service after 1986, which means it was used as a rental property after 1986 and is specific to the type of depreciation method you’re using; as we previously mentioned we use the GDS method
- An income-producing property that is expected to last more than one year, which is generally true of all rental properties
- Residential real estate used to produce income
- Owner-occupied commercial real estate like a building where you operate your business
- Income-producing commercial real estate like an office building or shopping center
- Multifamily properties like buildings with two or more separate units such as a duplex or triplex
Rental Property Depreciation Method
There are certain rental property depreciation rules that the IRS expects you to follow. They include using the MACRS that spreads costs and depreciation deductions over 27.5 years for residential properties and 39 years for commercial properties. Keep in mind that we are using the GDS of MACRS and not the ADS.
Now, let’s look at the formula for MACRS which is the cost basis of the asset multiplied by the depreciation rate. The cost basis is the same as the purchase price of the property. You can find which depreciation rate you should use in one of the three tables the IRS provides in Publication 946.
MACRS Formula Using GDS = Cost basis of the asset x Depreciation rate
Let’s look at an example of how to use the MACRS formula.
The IRS establishes that any residential rental property placed in service after 1986 is depreciated using the useful life of the property. Although the MACRS formula is simple, we suggest consulting with a tax professional to calculate MACRS because the depreciation rate used varies depending on the type of asset being depreciated.
Although MACRS is used on the real estate itself, typically, the straight line depreciation method is used on other improvements. This means that these items can be depreciated and deducted over time such as a new roof or new windows, doors, plumbing systems, etc.
For more information on rental property tax deduction rules, check out our in-depth guide on rental property tax deductions and benefits.
Rental Property Depreciation Schedule
A rental property depreciation schedule helps you value your assets, calculate your depreciation expenses, and calculate your capital expenses. A rental property depreciation schedule shows what kind of depreciation you can take and deduct each year. It shows the breakdown of the land value and the building value because you can only depreciate the building value. It’s based on the useful lifespan allowed by the IRS for the property type.
A rental property depreciation schedule generally includes the:
- Property type you’re depreciating: Such as buildings and structures, office equipment, machinery, furniture or vehicles on a property
- Type of depreciation used: For example, if you’re using the more common GDS method or the alternative method (ADS)
- Cumulative depreciation to date: This is how much the asset has depreciated from the time it was put in service until the present date
- Future depreciation forecast: This is a prediction of how much depreciation the asset will incur during a certain period of time in the future
Reporting Depreciation of Rental Property
Now that you know what rental property depreciation is and how it works, you need to know where to report it, especially if you’re doing your own taxes. Although we do recommend working with a tax professional, it may be helpful to know where to report depreciation of rental property on your tax documents.
Here are three steps to help with reporting residential rental property depreciation.
1. Use a Schedule E to Record Income and Expenses
Typically, you will receive a 1040 federal income tax return, and you will use the Schedule E to record all of your rental property income and expenses. Generally, your accountant will help you fill this out.
2. Figure Out Your Net Gain or Net Loss
After you fill out the Schedule E, you figure out if you had a net gain or a net loss and record how much it is on the 1040 form. One of the major expenses that should be listed on your Schedule E is your rental property depreciation. This is where you depreciate expenses that have a useful life of more than one year.
Typical expenses that you need to depreciate on a rental property include:
- New roof
- Replacing a bathroom
- Replacing a kitchen
The formula that you should use to depreciate these expenses is:
- Divide the total cost of the item by the useful life of the improvement
Then you write that expense as a fraction. For example, if you spend $15,000 on a driveway with a 15-year useful life, you divide $15,000 by 15 and get $1,000. This means you can write off $1,000 per year during the driveway’s useful life.
3. Depreciate the Purchase of the Property
You can do the same thing as in step 2 when you purchase the property, which is usually your largest real estate related expense. However, the useful life of a residential rental property building is 27.5 years, and the land can’t be depreciated, so you need to subtract the cost of the land from the total property cost.
Let’s look at a quick example:
You purchase a property for $300,000. The land is worth $125,000, and we already know the useful life of a residential building, according to the IRS is 27.5 years. Now, let’s figure out how much the building is worth by itself. We subtract the land from the total property cost and get $175,000.
$300,000 – $125,000 = $175,000
Now, we know the building is worth $175,000, and we want to depreciate it over 27.5 years, so we divide it by 27.5 and get $6,363.64.
$175,000 / 27.5 = $6,363.64
This is the amount you can take as a depreciation per year on the purchase of your investment property. This reduces your tax liability by $6,363.64 per year while keeping your cash flow the same. Basically, you’re adjusting your cost basis downward each year by the amount of depreciation taken.
Rental Property Depreciation Recapture
Rental property depreciation recapture is the gain that the real estate investor receives from selling the investment property, and it must be reported as income to the IRS. This can hurt an investor because it’s additional income that you have to pay taxes on based on your ordinary tax rate, which can be in addition to capital gains tax. Depreciation of rental property should be reported on IRS Form 4797.
When you take depreciation, you’re adjusting the property’s cost basis downward. So, when you sell the property, you have to pay taxes on it because you previously offset some of your ordinary income taxes by claiming depreciation. Depreciation recapture is assessed when the property’s sales price exceeds its adjusted cost basis. An adjusted cost basis just means the net cost of the asset after it’s been adjusted for depreciation. We’re going to explain this in more detail in six steps.
Keep in mind that capital gains tax on real estate is also due when you sell an investment property for more than you purchased it for. Part of the profit is taxed as a capital gain and may qualify for the 20 percent capital gains tax, and the other part of the profit is taxed at the ordinary tax rate, which is generally higher than the capital gains tax rate.
Part of the profit that is taxed at the ordinary tax rate because it was depreciated over time. This can get complicated, so we suggest consulting with a tax professional. The IRS uses rental property depreciation recapture as a way to collect taxes on profits from the sale of a rental property. This is because the taxpayer was able to previously write depreciation off against their taxable income during their ownership of the property.
Residential Rental Property Depreciation Recapture Example
We’re going to show you six steps to calculate depreciation recapture. First, we need to know the tax basis of the property, which is the same as the property’s purchase price plus closing costs and any capitalized expenses. We also need to know the adjusted cost basis which is the purchase price minus the annual depreciation multiplied by the number of years of ownership.
Now, let’s look at a rental property depreciation recapture example in six steps.
1. Purchase a Rental Property
Let’s assume that Jane purchased a residential income producing property for $350,000. Now, let’s assume the property has an annual depreciation of $20,000, and Jane decides to sell the property after 11 years for $430,000.
2. Calculate the Adjusted Cost Basis of the Rental Property
To figure out the adjusted cost basis, we use the purchase price minus the annual depreciation rate multiplied by the number of years of ownership, and we get $130,000.
$350,000 – ($20,000 x 11) = $130,000
3. Calculate the Realized Gain on the Rental Property
Then, we figure out the realized gain on the property by subtracting $130,000 from $430,000, and we get $300,000.
4. Calculate the Capital Gain on the Rental Property
The capital gain will be $300,000 – ($20,000 x 11), which = $80,000, and so the recapture gain is $20,000 x 11, which is $220,000.
5. Know Your Tax Brackets
Now, let’s assume a 20 percent capital gains tax and a 28 percent income tax bracket. The total amount of tax that Jane will pay on the rental property will be (0.20 x $80,000) + (0.28 x $220,000) = $16,000 + $61,600 = $77,600.
6. Calculate the Depreciation Recapture Amount
The depreciation recapture amount is 0.28 x $220,000, which is your tax bracket, expressed as a percentage, multiplied by the recapture gain.
The depreciation recapture amount will be $61,600.
As you can see from the above example, it’s quite complicated, but you were able to figure out the depreciation recapture amount. So, now you know how much you will pay when you sell a property, and you can decide if it’s worth selling and what you need to sell it for. For more information on depreciation in general, including how it’s calculated, when to use it and how depreciation works, check out our in-depth guide on how depreciation works.
Now, let’s take a look at a couple of real estate professional’s thoughts on depreciation recapture.
“This is the depreciation recapture tax, and it’s designed to make sure you pay back the government roughly what you saved in taxes over the years. Remember that the depreciation expense saved you from being taxed at the ordinary income tax rates, which are up to 37 percent now.”
— Domenick Tiziano, Owner, Accidental Rental
“Depreciation recapture usually applies to improved real estate because that real estate will generally increase in value over time while its improvements will depreciate with time and use. The recomputed basis will be used to determine any gain. If there is gain, it will be taxed as capital gain and, if there is a loss, it can be taken as a loss for the taxpayer.”
— Brenda Di Bari, Commercial Real Estate Broker, Halstead Real Estate
Depreciation of Rental Property Frequently Asked Questions (FAQs)
Below, we’re going to answer the most frequently asked questions about real estate depreciation, including rental property tax deductions because depreciation of rental property is one of the largest rental property tax deductions. If you have further questions or would like to comment about depreciation of rental property, please feel free to visit the FitSmallBusiness forum.
What Depreciation Method Is Used for Rental Property?
The depreciation method used for rental property is MACRS. There are two types of MACRS: ADS and GDS. GDS is the most common method that spreads the depreciation of rental property over its useful life, which the IRS considers to be 27.5 years for a residential property.
What Happens to Real Estate Depreciation When You Sell the Property?
When you sell your rental property, you typically have to pay a depreciation recapture tax if you sell the property for more than its depreciated value. The depreciation recapture tax is typically 20 percent plus the state income tax on the depreciation amount that you claimed. However, the exact amount depends on your income tax bracket.
If you want to hold off on paying this depreciation recapture tax, you may want to consider a 1031 exchange. To find out more about a 1031 exchange, read our in-depth guide on section 1031 exchange.
Do You Have to Take Real Estate Depreciation?
You don’t have to take real estate depreciation. However, it’s recommended that you do because it’s one of the main rental property tax deductions. Also, the IRS assumes that you do take depreciation, so will have to pay a depreciation recapture tax when you sell the property whether or not you take the depreciation.
The Bottom Line
Real estate depreciation is a way to expense the costs of your rental property over time and lower your tax burden. Real estate depreciation is based on the type of property and its useful life as determined by the IRS. The IRS’ depreciation schedule for residential real estate is generally 27.5 years and 39 years for commercial property.
Use QuickBooks to help keep track of your rental property depreciation, including your depreciation of rental property schedule. It’s a reputable accounting software used by real estate investors. It offers a free 30-day trial, so take advantage of that and sign up now.