Depreciation is an accounting term that refers to a loss in value over time. All assets and products, including real estate, lose their value as time passes. Rental property depreciation allows you to deduct this loss of value as an expense on your taxes when you own income-producing real estate.
Table of Contents
What Is Rental Property Depreciation?
How to Calculate Depreciation on Rental Property
Real Estate Depreciation Rules in 2024
Do You Have to Depreciate a Rental Property?
Rental Property Depreciation Bottom Line
What Is Rental Property Depreciation?
Rental property depreciation is the rate at which real estate investors can depreciate their property and take tax deductions on it. The IRS permits rental property owners to deduct a set percentage of the property’s cost basis from the taxes owed on the generated income over the useful life of the property. Typically, the rental property depreciates over 27.5 years, at a rate of 3.64% per year.
Depreciation can save real estate investors hundreds of thousands of dollars over the life of the property. However, the IRS has strict rules regarding rental property depreciation, so be sure you consult a tax professional to get the full deduction. You should also be familiar with how rental property depreciation recapture works before you sell your property.
How to Calculate Depreciation on Rental Property
- Determine Your Cost Basis
- Add Any Qualified Closing Costs
- Calculate Depreciation
1. Determine Your Cost Basis
The first step to calculating depreciation is to determine your cost basis. Depreciation is calculated as a percentage of the cost basis, not the property’s market value. Your cost basis refers to the amount you paid for the property plus any improvements or qualified closing costs. Also, because land does not depreciate, only the home’s value must be factored into the cost basis.
Let’s say you paid $200,000 for a rental property, but it’s sitting on a $40,000 plot of land. You also plan on spending an additional $30,000 to renovate it before selling.
To calculate your initial cost basis, you would take:
Purchase price – land value + improvements = 200,000 – 40,000 + 20,00 = $180,000
2. Add Any Qualified Closing Costs
Next, you can also add qualified closing costs to your cost basis. Remember that the higher your cost basis, the more you can depreciate, so you want to add as many permittable fees as possible.
Qualified Closing Costs Include:
- Property Taxes
- Abstract fees
- Recording Fees
- Transfer Taxes
- Survey fees
- Title fees
- Debts and fees you agree to assume for the seller (such as real estate commissions, mechanics liens, back taxes, etc.)
Say you add up all the additional fees, up to $8,000. Then your new cost basis would be $188,000.
3. Calculate Depreciation
Finally, to calculate depreciation, you simply take your cost basis and divide it by the useful life of the property. Let’s use the example above of a property with a cost basis of $188,000 and divide it by the GDS lifespan of 27.5 years.
The calculation looks like this: 188,000 / 27.5 = $6,836.36
That means you can deduct an additional $6,836.36 annually from your taxable income in depreciation.
Real Estate Depreciation Rules in 2024
The IRS sets strict rules regarding which properties qualify for depreciation and how it can be deducted. Otherwise, it would be far too easy to take advantage of this technique. Here are some of the standard rules that property owners should understand.
1. What Properties Qualify
First, it’s essential to know if your property qualifies for depreciation. The IRS requires the following conditions be met before you can depreciate a rental property:
- You must own the property (although you aren’t required to own 100% of the equity and can still depreciate the property with a mortgage).
- You must use the property in a business capacity or as an income-producing asset.
- The property must have a determinable useful life (for instance, raw land can’t depreciate because it doesn’t wear out, decay, or become obsolete).
- The useful life of the property must last more than a year.
2. When Does Depreciation Start?
Depreciation begins as soon as the property is ready and available to renters. So, remember that this may not be when you purchase the property or rent it out.
Say, for instance, you buy a home on June 1st, but it still needs maintenance. The renovations are finished on July 15th, when you put it on the market. You find a tenant reasonably quickly, but their lease doesn’t begin until August 1st.
In this case, depreciation would start on July 15th, not June or August 1st, because that’s when the property was first available for service.
3. How Long Does Depreciation Last?
You can deduct 100% of the property’s value over the entire recovery period, which comes out to about 3.636% per year (100 / 27.5). However, the IRS does allow you to depreciate specific improvements faster than 27.5 years. For instance, appliances can be depreciated on a five-year schedule because their useful life is shorter. You may want to consult a tax professional and use a different schedule to track separate improvements
Do You Have to Depreciate a Rental Property?
No, depreciation isn’t mandatory, but it is highly recommended for anyone who owns an investment property. Aside from maybe having to hire an accountant to help you keep track of your depreciation schedule, there is little downside to depreciating a rental property (which you probably should have anyway).
While it may seem a bit overwhelming at first, depreciation can potentially save you hundreds of thousands of dollars in the long run, especially if you plan on building an extensive portfolio. So, while it isn’t legally required, it would be a mistake not to take advantage of depreciation.
Rental Property Depreciation Bottom Line
Depreciation is a powerful concept that allows rental property owners to account for the expected loss in value over time. The typical depreciation schedule for a rental property lasts close to 30 years, which means you can continue reaping the benefits for several decades. It can get somewhat complicated to keep track of everything. But as long as you develop a system to track your expenses and determine an accurate cost basis, you’ll be able to deduct several thousands of dollars or more from your taxable income each year.