Ever hear that “real estate investors pay next to nothing in income taxes”? While not entirely true, real estate investors do enjoy sweeping tax deductions. From writing off most closing costs to maintenance and repairs, landlord insurance to rent default insurance, property taxes to property management fees, landlord tax deductions include every conceivable expense. Including some paper expenses that they don’t actually incur year-to-year, such as rental property depreciation.

This oft-misunderstood tax deduction saves real estate investors thousands of dollars on their taxes. Play your cards right, and you can compound this tax savings by using them to buy ever more investment properties and keep snowballing your passive income.

But how is rental property depreciation calculated? How does it work? As you plan out your investing tax strategy, here’s what you need to know about rental property depreciation, including a free rental property depreciation calculator.

Depreciation Rules for Rental Properties

First, the deprecation rules apply only to investment properties. You can’t depreciate your own home. But you get other deductions for owning a home, plus perks like homeowner financing even when you house hack.

Depreciation only applies to non-owner-occupied income properties. The IRS lets you deduct for the building’s natural depreciation, since it’s a physical structure that deteriorates and loses value over time without maintenance and repairs. You can’t depreciate the value of the land, since it doesn’t deteriorate.

To qualify, you must own the property for longer than one year. If you flip houses, for example, you can’t use depreciation unless you hold onto the property for longer than a year. This would defeat the purpose of fixing and flipping, so it doesn’t make sense.

If you own an investment home, you may depreciate it for the first 27.5 years or until you sell the home. This works out to 3.636% per year.

Know your Cost Basis

Before you can figure out your deprecation, you must know your cost basis. It starts with the home’s purchase price but does not include the land value.

For example, if you buy a property for $200,000, but the land is worth $30,000, you may only use $170,000 for your cost basis for depreciation purposes.

To the property price, you may add allowable fees. This includes closing costs and capital improvements you made to the home. The more fees/costs you add to the purchase price, the higher your cost basis becomes. A higher cost basis allows more deprecation.

Closing costs you may include to increase your cost basis include:

• Attorney costs as they pertain to the property purchase
• Survey fees
• Recording fees
• Title search and insurance costs
• Transfer taxes
• Debts you assume from the seller and pay

You may also depreciate the cost of capital improvements you make over the course of your ownership. Capital improvements include any property updates that extend the usable life of the property or improve its value. You add the cost of these improvement to the cost basis above (property price minus land value). The IRS calls this the “marked-up” or adjusted cost basis.

Examples of depreciable capital improvements include:

• A new roof
• Adding a room
• Replacing the flooring
• Renovating the garage or basement
• Installing new mechanical systems (e.g. electrical wiring or HVAC)

‘Normal’ home maintenance and repair costs don’t affect your cost basis. You write them off in your normal operating expenses, so you get the deduction in the same year, rather than spreading it out over time using a rental property depreciation schedule.

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How Depreciation Schedules Work

Rental property depreciation schedules allow you to deduct the cost of the building itself, but not all at once in a single year. You spread the deductions out evenly over 27.5 years.

In other words, you take the cost basis of the building (not the land!) and divide it by 27.5 years to calculate your annual deprecation amount. That comes to 3.636% of the building’s cost basis, that you can deduct each year for the next 27.5 years.

Note that rental properties follow straight-line depreciation. That makes the calculations simpler, as the deduction remains the same each year (other than the first and last years). If your really want your eyes to cross, read more details on the IRS’s various Modified Accelerated Cost Recovery System (MACRS) depreciation methods here.

In the first year, you prorate the depreciation amount, based on the number of months you owned the property. You can only deduct partial depreciation for the first year, based on how many months of the year you owned the property, and then take the full year’s depreciation thereafter.

Here’s how much depreciation you can take for the year you buy the property, based on the month when you purchase:

Rental Property Depreciation Calculator

Knowing a property’s depreciation value helps make investment decisions. If you know you can depreciate a property say $5,000 a year, it makes it a lucrative investment. You know you can knock $5,000 off the top of your income, and when combined with other deductions, may leave you with little to no tax liabilities.

This rental property depreciation calculator helps you make fast decisions by seeing the depreciation amount instantly.

The Power of Rental Property Depreciation as a Tax Advantage

Depreciation is one of the few tax deductions real estate investors use that isn’t a “true” expense. For example, you write off home repair expenses. You had to pay money to repair the home, so you write off the expenses.

You don’t pay depreciation each year, it’s simply part of your purchase price. The IRS gives you the deduction (3.636% of the cost basis) each year that you own the property. For example, if you have $10,000 in annual income from a rental property, and you have $4,000 in depreciation, your taxable income is $6,000 rather than $10,000.

Many landlords even show a loss on their tax returns when they actually earned strong real estate cash flow, but the deprecation lowered their taxable income enough that they show a loss.

Rental Property Depreciation Recapture

Writing off the deprecation feels great – while you own the investment property. Once you sell it, though, the IRS wants their money back, in the form of depreciation recapture. You have to pay income taxes on the money you previously deducted for depreciation.

Sounds like it’s not worth deducting for rental property depreciation? Consider two reasons why it’s absolutely worth taking.

First, the landlord tax deduction for investment property depreciation comes off your regular income tax. While you do get charged at the regular income tax rate for depreciation recapture, the IRS caps it at 25%, which limits the tax liability for higher earners. 

Second, you postpone having to pay taxes to Uncle Sam, penalty-free. In fact, you have many options to avoid capital gains tax on real estate entirely! Among others, you can scale your real estate portfolio tax-free with an investment property 1031 exchange.

If you sell the current rental home and use the money to buy another investment property, you can defer paying capital gains taxes – including investment property depreciation recapture – on the sold property. It’s a complicated process, but in the end, you use all the funds earned from the sale of one investment home to buy another and you avoid the rental property depreciation recapture.

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What If You Don’t Take Investment Property Depreciation?

If you weren’t aware of the depreciation deduction, you may own an investment home and paid taxes on your full rental income this entire time.

If you still own the home, you can amend your returns. Go back as far as you’ve owned the home and amend each year’s returns to take advantage of the depreciation. You must file 1040X and Schedule E at a minimum, but talk with your tax advisor to make sure.

You don’t have to deduct for depreciation in your tax return each year, and abstaining from doing so saves you from rental property depreciation recapture when you sell the property. But as outlined above, depreciation recapture is a small price to pay, and you may never end up having to pay capital gains taxes on your real estate anyway.

An Example of Real Estate Depreciation

Let’s look at the power of real estate depreciation and how it may help you.

You bought a home in June for $200,000 and the land is worth $30,000. Your building value is $170,000. Now let’s say you made $10,000 in capital improvements. Add that to your $170,000 for a building cost basis of $180,000.

Depreciated over 27.5 years, that comes to $6,545 in annual depreciation, and you can deduct a prorated amount of $3,546 in the first year. The annual depreciation comes off the top of your net operating income. Let’s say you bring in $12,000 a year in rental income, but have $4,000 in operating expenses. That leaves you with $8,000 in net income, but you can deduct the $6,545 from the $8,000 for $1,455 in taxable rental income.

Depending on your tax situation, the depreciation write-off may even knock you into a lower tax bracket, creating even more savings.

Then you decide to sell the property after ten years, for $300,000. You owe capital gains taxes on $90,000, as your cost basis is $210,000: purchase price of $200,000 plus $10,000 in capital improvements. Plus you also owe depreciation recapture — at your regular income tax rate, though capped at 25% — on the $62,451 you had deducted for depreciation ($3,546 from the first year, plus nine years at $6,545/year).

Final Word

Rental property depreciation marks one of the greatest deductions real estate investors have. If you haven’t taken advantage and you own a rental property, go back and claim what’s yours.

Remember, you must own the rental property for at least one year to deduct for depreciation. If you sell the property, keep in mind the recapture tax so you use the money wisely. Plan accordingly for the eventual taxes you’ll pay but enjoy the depreciation write-off while you get it.♦

Have questions about how rental property depreciation is calculated, or depreciation recapture? What still has you stumped?

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