How to Calculate Depreciation on Rental Properties

Depreciation allows property owners to deduct the costs of buying and improving a property over its useful life. In turn, this reduces taxable income, offering significant tax benefits. To take advantage of these benefits, however, it’s necessary to know how to calculate depreciation on rental properties, which may involve consulting a financial advisor who focuses on tax planning to ensure accurate calculations and compliance with IRS guidelines

How Rental Property Depreciation Works

Depreciation is a fundamental concept for rental property investors, providing a valuable tax advantage by allowing the deduction of the property’s cost over time. When you purchase a rental property, the IRS permits you to recover some of its cost by claiming depreciation, which represents the gradual wear and tear on the property. This non-cash deduction can significantly reduce your taxable income, enhancing your overall return on investment.

The process of calculating depreciation begins by determining the property’s depreciable basis, which excludes the land value since land cannot be depreciated. The depreciable basis includes the purchase price and any related acquisition costs, such as legal fees and property improvements. The IRS assumes that the property will lose value evenly over the assigned period, allowing property owners to deduct a portion of the basis each year.

Depreciation for rental properties generally operates under the Modified Accelerated Cost Recovery System (MACRS), which applies a consistent annual depreciation rate to the property’s depreciable basis. This method ensures a steady deduction amount each year, providing predictable tax relief for investors. Importantly, while depreciation reduces taxable income, it does not affect the actual cash flow from the property, making it a powerful tool for enhancing investment returns.

It’s important to note that depreciation is subject to recapture when the property is sold. This means that the total amount of depreciation claimed over the years is taxed as ordinary income upon sale, potentially increasing the overall tax liability. However, the benefits of depreciation often outweigh the recapture taxes, especially when combined with other tax strategies, such as a 1031 exchange, which can defer the recapture taxes indefinitely.

To maximize the benefits of depreciation and ensure compliance with IRS regulations, consulting a tax professional is highly recommended. They can provide tailored advice and assist in maintaining accurate records, ensuring that you take full advantage of this tax-saving opportunity while avoiding any pitfalls.

Calculating Real Estate Depreciation

To calculate depreciation, you begin by determining the property’s basis, which includes the purchase price and any associated acquisition costs, such as legal fees and improvements. It’s important to subtract the land value from the total cost, as land is not depreciable. The remaining amount, known as the depreciable basis, is then used to calculate annual depreciation.

For residential rental properties, the IRS allows depreciation over 27.5 years, while commercial properties are depreciated over 39 years. The depreciation method used is the MACRS, which ensures consistent annual deductions. To calculate the annual depreciation, you’ll divide the depreciable basis by the relevant period.

Let’s consider a practical example: Suppose you purchase a rental property for $300,000. The land is valued at $50,000, leaving a building value of $250,000. Additional acquisition costs, such as legal fees and improvements, total $25,000. The depreciable basis is therefore $275,000 ($250,000 for the building, plus $25,000 in acquisition costs).

Using the MACRS method, you would divide the property’s $275,000 depreciable basis by the 27.5-year depreciation period. This results in an annual depreciation deduction of $10,000. You can apply this deduction each year, reducing your taxable income and thus your overall tax liability.

How to Determine the Adjusted Basis

A real estate investor touring a property.

The adjusted basis of a property represents the property’s value for tax purposes after accounting for various adjustments.

Figuring out the adjusted basis begins with the original cost basis, which includes the purchase price and any associated acquisition costs. The initial basis sets the foundation for determining gains or losses on the property’s sale and for calculating depreciation.

However, over time, the original cost basis is adjusted to reflect improvements, depreciation and other changes. Increases to the basis can include capital improvements, such as major renovations or additions, which add value to or extend the property’s life. Conversely, the basis is reduced by deductions for depreciation, casualty losses and any insurance reimbursements received for damage to the property. These adjustments ensure that the property’s value is accurately reflected for tax reporting and financial planning.

To determine the adjusted basis, you’ll do the following:

Start with the original cost basis.
Add the cost of capital improvements made during ownership.
Subtract the total amount of depreciation claimed over the years, as well as any other reductions like casualty losses or insurance reimbursements.

As an example, if a property was purchased for $300,000, had $50,000 in capital improvements and $30,000 in depreciation, the adjusted basis would be $320,000 ($300,000 + $50,000 – $30,000).

When selling a property, understanding the adjusted basis is essential for accurately reporting capital gains or losses. It directly impacts the taxable amount from the sale, as the difference between the selling price and the adjusted basis determines the capital gain or loss.

Additionally, having a precise adjusted basis helps in planning for depreciation recapture taxes, which apply when the property is sold and the previously claimed depreciation is taxed as ordinary income.

Benefits of Real Estate Depreciation

Real estate depreciation offers substantial benefits, making it a valuable tool for property investors. Here are four major upsides:

Ability to reduce taxable income. By spreading the cost of a property over its useful life, investors can claim an annual depreciation deduction, which lowers their taxable income. This rental property deduction is a non-cash expense, meaning it doesn’t affect the actual cash flow from the property yet significantly reduces the tax liability, enhancing overall returns.
Boost in cash flow. Since depreciation lowers taxable income, it effectively decreases the amount of taxes owed each year. This tax savings translates to increased cash flow, allowing investors to reinvest in additional properties, pay down debt or cover other operating expenses. Over time, this enhanced cash flow can lead to greater financial stability and growth for property investors.
Impact on investment returns. By lowering tax liability and improving cash flow, depreciation increases the overall profitability of a rental property. This enhanced profitability can make real estate a more attractive investment. Additionally, the cumulative effect of annual depreciation deductions can significantly boost the long-term return on investment, making it easier for investors to achieve their financial goals.
Information for long-term financial planning. Understanding and utilizing depreciation can help investors plan for future expenses and investments. For instance, the tax savings generated through depreciation can be set aside for future property improvements or used to offset the cost of eventual repairs and maintenance. This proactive approach ensures that investors are better prepared for the financial demands of property ownership.

Bottom Line

Real estate investors assessing a property.

Understanding how to calculate depreciation on rental properties is essential for maximizing your investment’s tax benefits. When doing the calculations, remember to account for all acquisition costs and improvements while excluding land value to find the depreciable basis. Consulting a tax professional can ensure compliance with IRS guidelines and optimize your depreciation strategy. Properly leveraging depreciation not only lowers tax liability but also supports long-term financial planning, making real estate investments more profitable and sustainable.

Tips for Real Estate Investments

A financial advisor can help you create a plan for your real estate investments. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
If you’re taking on financing with your investment, consider using a mortgage calculator to estimate what you might end up paying.