As a property owner, knowing how depreciation works and how it affects your investment is crucial to maximizing returns. Like any asset, real estate wears down over time. Although the IRS acknowledges this and allows you to deduct depreciation as a tax benefit.
When used correctly, depreciation can help offset your rental income and reduce your overall tax liability. As a property owner, knowing how depreciation works and how it affects your investment is crucial to maximizing returns.
In this guide from Home Choice Property Management, you’ll learn how depreciation impacts your rental property’s value, how to use it for tax benefits, and strategies to reduce your tax liability.
What Is Rental Property Depreciation?
Depreciation refers to the natural decline in value of a physical asset over time due to wear and tear, aging, or even external factors like market changes.
In the context of rental real estate, it’s the process by which you deduct the cost of the building, not the land, over a period of time as it’s used for income-generating purposes.
Even though your property may appreciate in market value, the IRS still allows you to account for its physical deterioration over time. This recognition forms the basis of rental property depreciation.
How Depreciation Works for Rental Real Estate
The IRS classifies rental properties as capital investments, allowing you to deduct the building’s value, not the land, over time.
For residential rentals, you can depreciate the property over 27.5 years, reducing your taxable income annually. Other uses, like business or agriculture, may have longer depreciation periods depending on classification.
What Is the Depreciation Recovery Period?
The recovery period is the time allowed to deduct an asset’s cost. Residential rentals use a 27.5-year schedule, while commercial properties use 39 years.
In comparison, items like furniture depreciate in just 5 to 7 years. This longer period reflects real estate’s durable value and supports long-term tax planning.
Calculating Annual Depreciation
To determine your yearly depreciation deduction, begin by subtracting the land value from the property’s total purchase price. Land is not subject to depreciation because it doesn’t wear out or become obsolete over time.
Once you’ve established the building’s value, divide that figure by the recovery period (27.5 years for residential properties). The resulting number is your annual depreciation expense, which you can deduct from your rental income each year.
For example, if the building portion of your rental property is valued at $275,000, you can deduct $10,000 annually in depreciation.
You may also add the cost of certain improvements to your depreciation basis but not routine repairs or maintenance. Capital improvements like new roofs, HVAC systems, or additions can be included and depreciated over time.
Depreciation and Tax Benefits
One of the most valuable tax advantages of owning a rental property is depreciation. Unlike expenses such as insurance, repairs, or travel, which are deducted in the year they occur, depreciation lets you spread a significant deduction across nearly 30 years.
This yearly write-off reduces your taxable income and may lower your overall tax liability. That said, it’s important to plan ahead.
While depreciation offers short-term tax savings, it can trigger depreciation recapture taxes when you sell the property. Understanding this trade-off is essential to managing your investment wisely.
What Is Depreciation Recapture?
Depreciation recapture is a tax applied when you sell a property for more than its adjusted cost. The IRS assumes you’ve been deducting depreciation each year, and when you sell, it wants to “recapture” some of that tax benefit.
The taxable portion is generally calculated as the difference between the original purchase price (minus land) and the adjusted value after all depreciation deductions have been taken. This amount is taxed at a maximum rate of 25%, depending on your income bracket.
For example, if you depreciated $50,000 over several years, you could owe up to $12,500 in recapture taxes when you sell unless you apply certain strategies to defer it.
How to Defer Depreciation Recapture Tax With a 1031 Exchange
One powerful strategy for deferring both depreciation recapture and capital gains taxes is through a 1031 Exchange, named after Section 1031 of the IRS code.
This allows you to reinvest the proceeds from the sale of one rental property into another “like-kind” property without paying taxes immediately. To qualify, the replacement property must be of equal or greater value, and you must continue using it for rental or business purposes.
Additionally, strict deadlines apply: you have 45 days to identify up to three potential replacement properties and 180 days to complete the purchase.
By using a 1031 Exchange correctly, you can delay paying depreciation recapture until you sell the new property and if you continue exchanging, possibly defer it indefinitely.
Special Considerations When Claiming Depreciation
Depreciation isn’t a blanket deduction, there are key details to get right. Most notably, only the building portion of your rental property qualifies for depreciation, not the land it sits on.
Failing to separate these values can result in overclaiming and potential IRS penalties. Use tax records or an appraisal to properly allocate the cost between land and structure.
Who Can Claim Depreciation?
Not every property owner qualifies to claim depreciation. To be eligible, you must meet the following conditions:
- You must legally own the property, whether it’s financed or purchased outright.
- The property must be used to generate rental income.
- The asset must have a determinable useful life of more than one year and be expected to lose value over time.
- The property must be held for a year or more, not for quick resale or flipping.
If these criteria are met, you can begin depreciating your property starting the year it’s placed into service.
Bottom Line
Depreciation is a powerful tax-saving tool that lets landlords recover the cost of property wear and tear while boosting annual profits.
Though it reduces taxable income each year, it may trigger depreciation recapture tax upon sale unless deferred through strategies like a 1031 Exchange. By understanding and applying depreciation wisely, you can make informed decisions, lower your tax liability, and expand your rental investments more effectively.
Need help navigating depreciation or planning a 1031 Exchange? Reach out to us at Home Choice Property Management, to ensure you’re making the most of your investment.