Depreciation of a Rental Property

How and Why to Depreciate Rental Property

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If you own rental property, over the years you will likely spend money to make fixes or improvements. The good news is that the IRS, allows you to claim a tax benefit for those expenses in the form of depreciation. Here's how that works.

Key Takeaways

  • You can offset some expenses you incur on maintenance and improvement of your rental property by claiming depreciation
  • The IRS allows you to depreciate the value of a residential rental structure over a period of 27.5 years, though you cannot depreciate the value of land
  • You'd need to file Schedule E to Form 1040 and Form 4562 to claim some or all depreciation for your residential property

What Is Depreciation For Rental Property

The expense you incur on maintenance and improvements on your rental property is classified as a capital expense. You can recover some of that cost by claiming depreciation over the life of the property.

It's the logical result of the fact that buildings wear out over time, or they become obsolete due to older features that are no longer in demand. It also provides a great way to pare down the rental income that you must pay taxes on.

Note

The IRS will, generally, allow you to depreciate the value of a residential rental structure over a period of 27.5 years.

Rules for Rental Property Depreciation

We're talking taxes here, so, of course, there are some qualifiers. The rules for depreciation imposed by the IRS include:

  • You must own the property.
  • It must generate income—you don't hold it for your personal use.
  • Unlike land, it must have a definable "useful life." It will begin to deteriorate and lose value over time.
  • Property that is expected to last longer than a year

Note

You cannot claim depreciation on the value of land, because typically, land doesn't undergo wear and tear, nor does it become obsolete.

You can only take a depreciation deduction on Schedule E if you meet these circumstances.

You calculate depreciation on rental property using the adjusted basis, which means costs that you incur after you place the property to rental use.

An Example of Rental Property Depreciation

Using an investment fourplex as an example, begin with a purchase price of $325,000. Assume the property will generate $15,192 a year in positive cash flow if all four units are rented out full time.

Now you can offset some of that income for tax purposes. You can depreciate the building by deducting out the value of the land and dividing the remainder, the building value, by 27.5 years to reach a figure for annual depreciation.

The depreciation calculation would look like this:

  1. Purchase price less land value equals building value
  2. Building value divided by 27.5 equals your annual allowable depreciation deduction

Assume that the value of the half-acre of land on which the fourplex sits is $80,000. The calculation would look like this:

  1. $325,000 less $80,000 equals $245,000 building value
  2. $245,000 divided by 27.5 years equals $8,909 a year in depreciation

Without taking any other property tax or mortgage interest deductions into account, you've already reduced your taxable rental income by $8,909 annually. And you didn't have to spend any additional money to realize this deduction.

How To Claim Rental Property Depreciation

Depreciation is just one deduction you can take for your rental property. There are more savings to be found here.

Claiming a deduction for depreciation requires completing Schedule E with your Form 1040 tax return. You'll enter your annual depreciation here, as well as all the property taxes, interest, and maintenance expenses you paid all year.

Note

You might also need to file Form 4562 to claim some or all of your depreciation.

Rental Income and Retirement

Rental home investing is very popular, especially for new investors or for those who want monthly cash flow now rather than big, short-term profit boosts from wholesaling or fix-and-flip investing. Rental investing can accomplish a lot for you depending on your age and your remaining time until retirement.

You might find that there isn't a very high rate of return coming your way from dividends or interest as you near retirement age and you begin to calculate your monthly income from the stock market and other investments. You could reallocate your assets, selling stocks or bonds and moving that money into rental homes. 

There's less risk if you invest wisely, and the returns are typically higher. You'll have more monthly income to fund your looming retirement.

Retirement Planning When You're Young

This is when you can really start building a nice retirement. Begin buying properties as rentals and you'll start gaining equity as the years go by and they appreciate as you pay down the mortgages. 

You can take the profits from sales with a 1031 exchange when you sell, and roll them into more rentals, maybe higher-priced homes instead of more of them. A 1031 exchange involves rolling your profits from one property directly into a new property through a designated third party so the money never actually touches your hands.

Note

A 1031 exchange will let you avoid capital gains tax if you do it right. 

And if you don't have use of the money yet, it's not capital gains and it's not yet taxable.

The Bottom Line

Rental property investing will always be a great way to invest because there will always be renters. Rental home investment is resistant to the negative effects of interest rate increases and inflation. It can be a great way to grow your wealth. And rental property depreciation can add to that by offering a little tax benefit.

Frequently Asked Questions (FAQs)

How do you calculate depreciation on rental property?

To calculate depreciation on rental property, you need to figure out your adjusted basis. Adjusted basis is the cost adjustment you make to the cost of your property before you put it to rental use. After that, you divide the value by 27.5 years to arrive at your annual depreciation for your rental property.

How do you avoid depreciation recapture tax on rental property?

One way to avoid recapture tax on rental property is to engage in a 1031 exchange. You can take the profits from sales with a 1031 exchange when you sell, and roll them into more rentals, maybe higher-priced homes instead of more of them. A 1031 exchange involves rolling your profits from one property directly into a new property through a designated third party so the money never actually touches your hands.

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Sources
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  1. Internal Revenue Service. "Publication 527 (2020), Residential Rental Property - Depreciation."

  2. Internal Revenue Service. "Know the tax facts about renting out residential property."

  3. Internal Revenue Service. "Publication 527 (2020), Residential Rental Property - What Rental Property Can Be Depreciated?"

  4. Internal Revenue Service. "Publication 527 (2020), Residential Rental Property - What Rental Property Can't Be Depreciated?"

  5. Internal Revenue Service. "Publication 527 (2020), Residential Rental Property - Adjusted Basis."

  6. Internal Revenue Service. "Publication 527 (2020), Residential Rental Property - Which Forms to Use?"

  7. Internal Revenue Service. "Like-Kind Exchanges - Real Estate Tax Tips."

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