How to Depreciate Rental Property: The Savvy Landlord’s Guide

Depreciating rental property is, in essence, claiming a tax deduction for the gradual wear and tear your investment property experiences over time. It acknowledges that assets, like buildings, lose value due to aging, use, and obsolescence. The IRS allows you to deduct a portion of the property’s cost each year over its useful life, effectively lowering your taxable income and increasing your cash flow. This isn’t about physical deterioration; it’s an accounting method to recoup your investment.

Understanding the Basics of Rental Property Depreciation

Depreciation isn’t free money; it’s simply spreading out the cost of a significant asset over its lifespan. Think of it as slowly converting your initial investment into a tax deduction. It’s one of the most significant tax advantages available to real estate investors, but it requires understanding the rules and applying them correctly.

What Can You Depreciate?

Generally, you can depreciate the building itself (including permanent fixtures), as well as certain improvements made to the property. Land is never depreciated, as it’s considered to hold its value indefinitely. Furniture, appliances, and other personal property used in the rental can also be depreciated, but often under different rules (usually shorter recovery periods).

The Magic Number: 27.5 Years

For residential rental property, the IRS prescribes a recovery period of 27.5 years. This means you divide the depreciable basis of your property by 27.5 to determine your annual depreciation expense. Commercial rental properties use a 39-year recovery period.

Determining Your Depreciable Basis

Calculating your depreciable basis is the cornerstone of accurate depreciation. Here’s the process:

1. Start with the Purchase Price: This is the price you paid for the property.
2. Add Acquisition Costs: Include expenses like legal fees, title insurance, recording fees, and transfer taxes.
3. Subtract Land Value: This is critical. You cannot depreciate land. Allocate a reasonable portion of the purchase price to the land’s value. This is often based on appraisals or local tax assessments.
4. The Result: Your Depreciable Basis. This is the figure you’ll use to calculate your annual depreciation expense.

The Straight-Line Method: The Standard Approach

The most common depreciation method for rental property is the straight-line method. This means you depreciate the same amount each year over the 27.5-year recovery period.

Here’s the formula:

Annual Depreciation Expense = Depreciable Basis / 27.5

Example:

Let’s say you purchased a rental property for $250,000. Your acquisition costs were $10,000, bringing your total cost to $260,000. You allocate $50,000 to the land value.

• Depreciable Basis = $260,000 – $50,000 = $210,000
• Annual Depreciation Expense = $210,000 / 27.5 = $7,636.36

You would deduct $7,636.36 each year for 27.5 years.

Claiming Depreciation on Your Tax Return

You report depreciation expense on Schedule E (Supplemental Income and Loss) of your Form 1040. You’ll need to provide information about the property, its cost basis, the depreciation method used, and the amount of depreciation claimed for the year.

The Importance of Accurate Recordkeeping

Accurate recordkeeping is essential for successful depreciation. Keep all receipts, invoices, closing documents, and any records related to improvements made to the property. This documentation supports your depreciation claims and protects you in case of an audit.

Depreciation Recapture: The Catch

Depreciation is a powerful tool, but it’s crucial to understand depreciation recapture. When you sell the property, the IRS “recaptures” the depreciation you’ve claimed over the years. This means you’ll pay taxes on the accumulated depreciation as ordinary income, up to a maximum rate of 25%. It’s not a penalty; it’s simply accounting for the tax benefits you received during ownership.

FAQs: Mastering Rental Property Depreciation

Here are 12 frequently asked questions to provide even more clarity on this crucial topic:

1. Can I depreciate a property I don’t rent out year-round?

   Yes, you can still depreciate the property, but only for the period it’s available for rent. You’ll need to calculate the depreciation based on the number of months it was available.

2. What if I make significant improvements to the property?

   Improvements that add value, prolong the property’s life, or adapt it to new uses are depreciable. These are treated as separate assets and depreciated over their own recovery period (usually 27.5 years for residential rental property improvements). This is different from repairs, which are generally deductible in the year they are incurred.

3. What are some examples of depreciable improvements?

   Examples include adding a new roof, installing new windows, building an addition, or remodeling a kitchen.

4. What are some examples of repairs that cannot be depreciated?

   Repairs are things that keep the property in good operating condition, such as painting, fixing a leaky faucet, or replacing a broken window pane with one of similar quality.

5. What is Section 179 Deduction, and can I use it for rental property?

   The Section 179 deduction allows businesses to deduct the full purchase price of qualifying assets in the year they are placed in service. It generally doesn’t apply to residential rental property, but may apply to certain personal property used in the rental (e.g., appliances). There are very specific guidelines and limitations.

6. What is Bonus Depreciation, and can I use it for rental property?

   Bonus depreciation allows businesses to deduct a large percentage of the cost of qualifying new or used property in the year it’s placed in service. This generally doesn’t apply to residential rental buildings themselves, but might be used for shorter-lived assets used in the rental. Consult a tax professional for current regulations, as bonus depreciation rules change.

7. Can I take depreciation if I live in one unit of a multi-family property and rent out the other units?

   Yes, you can depreciate the portion of the property that is used as a rental. You’ll need to allocate the property’s cost basis between the portion used for rental and the portion used as your personal residence.

8. What happens if I don’t claim depreciation one year?

   You are still considered to have taken the depreciation, even if you didn’t claim it. This is called “allowable” depreciation. When you sell the property, you’ll still be subject to depreciation recapture, even for the depreciation you didn’t claim. This is why it’s generally advantageous to claim depreciation each year.

9. How do I handle depreciation when selling the property?

   When you sell, you’ll need to calculate the accumulated depreciation you’ve claimed over the years. This amount will be subject to depreciation recapture tax at a maximum rate of 25%.

10. What is cost segregation?

    Cost segregation is a tax strategy that involves identifying and reclassifying property components from real property (depreciated over 27.5 or 39 years) to personal property (depreciated over shorter periods, like 5, 7, or 15 years). This can accelerate depreciation deductions and increase cash flow. It typically requires a professional cost segregation study.

11. How does inherited property affect depreciation?

    When you inherit property, your basis is generally the fair market value of the property on the date of the decedent’s death. You can then depreciate this basis over the applicable recovery period.

12. Should I hire a professional to help with depreciation?

    While you can calculate depreciation yourself, it’s highly recommended to consult with a qualified tax advisor or accountant, especially if you have a complex situation. They can help you accurately determine your depreciable basis, choose the appropriate depreciation method, and ensure you’re complying with all IRS regulations. This can save you money and avoid potential penalties down the road.

Depreciating rental property is a powerful wealth-building tool. By understanding the rules and utilizing this deduction effectively, you can significantly improve your investment returns and achieve your financial goals. Remember to keep accurate records and seek professional guidance when needed.