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Depreciation is one of the biggest benefits of owning a rental property, along with the potential for recurring income and appreciation in property value over the long term.
But while income and equity can increase a tax burden, depreciation expense helps to decrease or even eliminate taxes owed on the income a rental property generates.
In fact, it’s possible for an investor to own a rental property that’s cash-flow positive while paying nothing in taxes.
Key Takeaways
Residential rental property owned for business or investment purposes can be depreciated over 27.5 years, according to IRS Publication 527 , Residential Rental Property.
Depreciation is based on the concept of an asset having a “useful life.” Depreciation expense is meant to compensate a rental property owner for normal wear and tear to the building over a period of time. Land value is exempt from depreciation, because land never wears out or is used up.
To calculate depreciation, the value of the building is divided by 27.5 years. The resulting depreciation expense is deducted from the pre-tax net income generated by the property. The income remaining after deducting the depreciation expense is passed through to the owner, and taxes are paid based on the owner’s federal income tax bracket .
Of course, most rental property doesn’t completely wear out and become unusable in less than 30 years. There are plenty of homes that were built 50, 75, or even 100 years ago that are still used as rental properties today. Over the years, they’ve been maintained to attract good tenants and to continue generating income for the owner.
Rental property depreciation continues during the holding period of the property, and resets to another 27.5 years for a new owner when the property is sold. If an owner holds the property for more than 27.5 years the depreciation expense runs out because the building’s useful life has expired, at least for the purposes of rental property depreciation.
A property must qualify for depreciation before an investor can claim a rental property depreciation expense. There are several criteria a real estate investor must meet in order to depreciate rental property:
There are three different ways to depreciate residential rental property . All three rental property depreciation methods refer to when the property is “placed in service” which means when the property is ready and available for rent.
Accurately calculating rental property depreciation can obviously be complicated. That’s why many real estate investors pay a tax professional or sign up for a free account with Stessa to accurately track the depreciation expense of a rental property.
In addition to automatically tracking rental property depreciation, Stessa’s new rental property balance sheet simultaneously updates each property to market value (versus depreciated value) to give real estate investors a more accurate idea of property equity.
Over 200,000 landlords also use Stessa, getting access to features like:
Now let’s take a look at a simplified example of how to calculate rental property depreciation using the straight line method of depreciation.
A single-family home in Austin, Texas was purchased by a real estate investor and was placed into service as a rental property on January 1, 2017. According to Zillow , the home value was $391,000. During a four year holding period, the home appreciated in value to $521,000. The investor decides to sell and the transaction closes on December 31, 2020, just in time for the new year.
1. Determine Rental Property Cost Basis
Before the investor can calculate rental property depreciation, the cost basis of the home needs to be determined. Cost basis is the value of the home minus the value of the land the home sits on, plus any closing costs that must be depreciated including:
There are other costs that must be depreciated that aren’t normally seen in most residential real estate transactions, such as property taxes owed by the seller that the buyer assumed, the seller’s real estate commission owed to an agent, or the cost of installing utilities.
We’ll assume that the real estate investor incurred closing costs of $3,000 when the property was first purchased, which must be added to the cost basis and depreciated. In addition, according to the county assessor and appraisal report, the value of the lot was $25,000 when the home was purchased back in January 2017.
Based on this information, the investor can calculate the cost basis of the home:
2. Calculate Rental Property Depreciation Expense
To calculate the annual rental property depreciation expense, the cost basis of the property is divided by 27.5 years:
So, over the four-year holding period, the investor was able to claim a depreciation expense of $53,672.72 to reduce the amount of taxable net income.
Hypothetically, if the rental home generated a total pre-tax net income of $60,000 over the four year period, the investor would only pay taxes on $6,372.28 thanks to the rental property depreciation expense:
A real estate investor can claim a depreciation expense of 3.636% of the investment property value each year. However, in the real world, rental property isn’t normally purchased and sold on the first day of the year and the last day of the year.
To help make calculating depreciation easier, the IRS provides real estate investors with a table to help determine the depreciation percentage to claim based on the month the rental property was placed in service:
Costs Basis Depreciation PercentageFor example, if a rental property with a cost basis of $100,000 was first placed in service in June, the depreciation for the year would be $1,970:
In each of the following years, the depreciation expense would be $3,636.36:
In addition to depreciating the building, real estate investors can also depreciate items placed into service in a rental property faster than 27.5 years:
5-year depreciation: Appliances, carpeting, furniture
7-year depreciation: Office furniture and equipment
15-year depreciation: Roads and fences
For example, let’s assume an investor spends $8,000 on new carpeting and rebuilds a wooden backyard fence at a cost of $15,000. The extra depreciation expense would be:
Depreciation expense is a tax benefit of owning rental property. However, when the property is sold, the depreciation expense taken is “recaptured” by the IRS and taxed as regular income.
To illustrate, let’s use our real estate investor in Austin as an example.
During the four-year holding period, the investor claimed a total depreciation expense of $53,672.72 to reduce the amount of taxable income. When the property is sold, the investor is required to pay tax on the $53,672.72 up to a maximum rate of 25%, even if the investor is in a higher federal tax bracket.
The maximum amount of tax owed from depreciation recapture would be $13,418.18, with any remaining capital gain taxed at 0%, 15%, or 20% depending on the investor’s tax bracket.
Instead of paying tax on depreciation recapture and capital gains, many real estate investors conduct a 1031 tax deferred exchange . Rather than paying taxes to the federal and state governments, investors use that extra cash to purchase another rental property to grow their real estate portfolio.
Rental property depreciation can save real estate investors a significant amount of money in taxes. In fact, when a property is first purchased, depreciation expense can completely eliminate any tax due on income because cash flow is lower due to repairs and the costs of finding a new tenant.
When a rental property is sold, any depreciation expense is recaptured and taxed at the investor’s normal income tax rate, up to a maximum of 25%. To defer paying taxes on depreciation recapture and capital gains, many investors choose to conduct a 1031 exchange and use the money saved to purchase more real estate instead of paying the government.
*Stessa is not a bank. Stessa is a financial technology company.Terms and conditions, features and pricing are subject to change. This article, and the Stessa Blog in general, is intended for informational and educational purposes only, and is not investment, tax, financial planning, financial, legal, or real estate advice.
