Understanding Depreciation of Rental Property: A Comprehensive Guide

Navigating the Complexities of Rental Property Depreciation

For rental property owners, understanding depreciation is an important consideration for maximizing tax benefits and maintaining compliance with IRS regulations.

This tax deduction allows property owners to account for the wear and tear on their investment over time, potentially saving thousands of dollars annually in tax liability. However, working through the complexities of rental property depreciation requires careful attention to the rules and reporting requirements.

Key Takeaways

• Property owners use depreciation to deduct certain costs of a rental property over its useful life.
• Eligibility for depreciation requires the property to be owned, used for income, and have a determinable useful life.
• The modified accelerated cost recovery system (MACRS) is commonly used to depreciate residential rental properties.
• Calculating depreciation involves determining the property’s basis and applying the right method.
• Depreciation must be reported to the Internal Revenue Service (IRS) on Schedule E.

Understanding Rental Property Depreciation

Depreciation is the gradual decline in an asset’s value due to wear and tear, age, and obsolescence. For rental properties, it creates a tax deduction that owners use to recover some of the cost of their investment over time. Rather than deducting the entire allowed amount in the year you’ve bought a property, the IRS requires spreading this deduction across what it considers the property’s useful life.

Depreciation of rental properties has evolved since its 1913 introduction in the U.S. tax code. While owners initially estimated their property’s useful life, the 1981 Economic Recovery Tax Act standardized depreciation periods. The current system was established in 1986.

Using depreciation for rental properties reflects a fundamental principle in tax law, namely that rental properties generate income over many years and their costs should be allocated across those years.

While properties often appreciate over time, depreciation is recognized for tax purposes given the ongoing costs of aging structures and mechanical systems, even in rising markets.

Eligibility Requirements for Rental Property Depreciation

Not all properties automatically qualify for depreciation. To be eligible, the IRS states that a property must meet specific criteria:

1. The property owner must own the property outright, including if it’s subject to a mortgage. Renters, lessees, and property managers don’t qualify for depreciation deductions.
2. The property must be used in a business or income-producing activity, such as rental operations. Personal residences or vacation homes used primarily by the owner aren’t eligible unless they meet strict rental use requirements.
3. The property must have one or more permanent structures. Land can’t be depreciated because it doesn’t wear out.

Modified Accelerated Cost Recovery System

The modified accelerated cost recovery system (MACRS) is a standard method for depreciating residential rental properties in the U.S. Under MACRS, properties are assigned a recovery period of 27.5 to 30 years.

There are two variations of MACRS—the general depreciation system (GDS) and the alternative depreciation system (ADS). Property owners must choose which one they prefer for tax purposes. Once made, this choice is final throughout the property’s useful life.

General Depreciation System (GDS)

GDS is the standard method that most property owners use, and it is automatically applied unless ADS is specifically elected or required.

GDS provides a recovery period of 27.5 years (330 months) for residential rental properties and uses the straight-line depreciation method, meaning the depreciation deductions should be the same each year.

Other assets used for rental activities—such as appliances, fixtures, and furniture—can be depreciated using the accelerated methods under GDS (like the 200% declining balance method), which yield larger deductions in the earlier years. However, residential rental real estate must always use the straight-line method.

Alternative Depreciation System (ADS) 

ADS extends the period of useful life to 30 years (or up to 40 years for those placed in service before 2018), using the straight-line method for the property and any assets within it. While this means smaller annual deductions than GDS, ADS may be preferable or required in certain situations, such as:

• Properties used predominantly outside the U.S.
• Tax-exempt use properties
• Properties financed with tax-exempt bonds
• Properties owned by certain types of business entities (e.g., when owned by real estate investment trusts)
• Properties used by foreign persons or entities not subject to U.S. income taxes

Calculating Your Property’s Depreciation

The process of calculating depreciation begins with determining your property’s cost basis. This is the purchase price plus certain capitalized costs, including closing costs, fees, and any capital improvements made before or shortly after placing the property in service. From this total, you subtract the value assigned to the land (since land is not depreciable).

The resulting figure is your depreciable basis, which is the starting amount you’ll use for the depreciation period.

Example

Step 1: Compute the Depreciable Basis

Suppose you purchase a rental property with the following details:

• Purchase price: $250,000
• Closing costs: $5,000 (includes legal fees, commissions, transfer taxes, recording fees, title insurance, etc.)
• Capital improvements: $10,000 (e.g., initial minor renovations and repairs)
• Total initial cost: $250,000+$5,000+$10,000=$265,000
• Land value: $70,000 (non-depreciable)

Depreciable Basis = Total Initial Cost – Land Value

= $265,000 – $70,000 = $195,000

Step 2: Determine the Annual Depreciation

For residential rental property under the MACRS using the GDS, the recovery period is 27.5 years.

The full-year depreciation (if placed in service for a full year) is calculated as follows:

Annual Depreciation = (Depreciation Basis / 27.5) = ($195,000 / 27.5) = $7,090.91 per year (about $591 per month)

Step 3: Apply the Mid‑Month Convention

Residential rental property is often depreciated using the mid‑month convention. This means that regardless of when the actual service or lease date is during a month, the IRS treats the property as placed in service in the middle of that month.

Let’s assume the property is placed in service on April 15:

First Year

Depreciate from the midpoint (April 15) through Dec. 31, about 8.5 months

• First year depreciation: $591 × 8.5 = $5,023.50

Subsequent Full Years

A full 12 months of depreciation = $7,092

Final Year

The remaining depreciation is needed to fully recover the $195,000 basis.

• Since you used 8.5 months in the first year and 12 months in each of the following 26 full years, you’ve depreciated for 320.5 months, so 330 – 320.5 = 9.5 months remaining.
• Final year depreciation: $591 × 9.5 = $5,614.50

Tax Implications and Reporting Requirements

Depreciation must be reported on IRS Schedule E and filed with your tax return. This form details rental income and expenses, including depreciation deductions.

Note that depreciation is mandatory for rental properties, even if you choose not to claim it. The IRS will still assume you’ve taken the deduction when calculating depreciation recapture taxes upon the property’s sale.

Depreciation Recapture

When you sell a rental property, the IRS will reclaim part of the tax benefit you received from depreciation by taxing it at a rate of up to 25%. In essence, it “recaptures” those depreciation deductions by taxing that amount as ordinary income (up to certain limits).

Say you purchased a rental property for $200,000 ($160,000 for the building + $40,000 for the land). During eight years of ownership, you claimed $46,545 in depreciation deductions ($160,000 ÷ 27.5 × 8 years). You then sell the property for $250,000, representing a gain.

• The $46,545 in depreciation you claimed is “recaptured” and taxed at up to 25%. Your maximum tax is $11,636.
• The remaining gain of $50,000 ($96,545 net gain – $46,545) is taxed at capital gains rates (typically 15% for most taxpayers).

Important

Recapture applies whether or not you actually claimed the depreciation deductions you were entitled to take.

Common Mistakes and Pitfalls

• Failing to separate land value from the building’s value is a frequent error. Remember, land can’t be depreciated, and failing to make this distinction can result in incorrect deductions.
• Another common error is neglecting to start depreciation from the date the property is placed in service rather than the purchase date.
• Some owners also forget to account for improvements separately from repairs. While repairs are immediately deductible, improvements must be depreciated over time.

The Bottom Line

Rental property depreciation offers significant tax advantages for landlords, but it requires careful attention to detail and thorough record-keeping. While the concepts may seem complex, understanding the basics of depreciation can help you maximize your tax benefits while maintaining compliance with IRS regulations.

Working with qualified tax professionals can help ensure you’re taking full advantage of depreciation benefits while avoiding the common pitfalls.