How to Calculate Rental Property Depreciation

Property depreciation is the gradual reduction in the value of a property over time due to factors like wear and tear, which can be used for tax deduction purposes. Property depreciation is typically calculated using the straight-line method, which divides the original value of the property plus any additional costs associated with its purchase by the estimated period during which you expect the property to remain functional and generate income before it needs major repairs or replacement.

If you need help managing the tax liability of your rental property, consider reaching out to a financial advisor .

Understanding Depreciation

Depreciation reflects the gradual decrease in value of a rental property due to aging, wear and tear, or obsolescence. For tax purposes, the IRS allows property owners to deduct this decrease in value from their taxable income. The process of calculating depreciation is standardized, and it is essential that property owners follow the correct procedures.

How to Calculate Depreciation on Rental Property

The first step in calculating depreciation on your rental property is determining the property’s cost basis . The basis is generally the property’s purchase price plus any associated costs, such as legal fees, transfer taxes and improvements made to it before renting it out. It’s important to note that the land’s value is excluded from depreciation calculations, as land does not depreciate.

You’ll also want to take into account that depreciation begins when the property is placed in service, meaning when it’s ready and available for rent. For example, if a property is ready to rent on July 1, depreciation begins on that date, and the first year’s deduction is prorated based on the number of months the property was in service.

The Modified Accelerated Cost Recovery System

The IRS requires that landlords use the Modified Accelerated Cost Recovery System (MACRS) to calculate depreciation for residential rental properties. MACRS divides the useful life of residential rental properties into 27.5 years, allowing property owners to spread the cost of the property out over this period. This also allows for a consistent annual deduction, which can be helpful for financial planning and tax purposes.

To apply the MACRS, the total depreciable basis of the property (excluding the land value) is divided by 27.5. This calculates the annual depreciation expense. For example, if you purchase a rental property for $300,000, and the land is valued at $50,000, the depreciable basis of the property would be $250,000. Using the MACRS formula, you would divide $250,000 by 27.5 to get an annual depreciation expense of approximately $9,091.

If it is the first year the property is in service, you will prorate the first year’s depreciation based on the number of months the property was in service. As we mentioned above, if the property was placed in service on July 1, you would take half of the annual depreciation for the first year, which would be $4,545. Then, for the next 26.5 years, you can claim the full annual depreciation amount of $9,091.

Frequently Asked Questions About Rental Property Depreciation

What Happens If I Make Improvements to My Rental Property?

Any significant improvements you make after the property is placed in service should be added to the rental property’s cost basis , and then depreciated over its remaining useful life. This ensures that the costs of any improvements are accurately accounted for in depreciation calculations.

What Is Depreciation Recapture?

Depreciation recapture occurs when a rental property is sold. The IRS requires property owners to pay taxes on the depreciation deductions claimed over the years, which can result in a higher taxable gain upon the sale.

Can I Continue to Depreciate My Property After It Is Fully Depreciated?

No, once a property is fully depreciated (after 27.5 years under the MACRS), you cannot claim further depreciation deductions . However, any improvements made to the property can be depreciated over their own useful lives.

Bottom Line

Following the IRS guidelines and using the MACRS calculation can help you determine annual depreciation expenses on a rental property. This not only helps maximize tax deductions, but also enhance overall investment returns. Keeping precise records and understanding the impact of improvements and depreciation recapture can further optimize the financial benefits of owning rental properties.

Tips for Managing a Rental Property

• A financial advisor can help you implement a rental property strategy as part of your investment portfolio. 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 don't know whether you're better off with the standard deduction versus itemized, it’s a good idea to do some research and math; you might find that you'd save a significant amount of money one way or another. So it's best to educate yourself before the tax return deadline .

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