What Landlords Need to Know About Depreciation and Property Value

Key Takeaways

• Depreciation Lowers Taxable Income: Landlords can deduct a portion of their property’s value each year, reducing their overall tax burden and improving cash flow.
• Cost Basis Matters: The calculation starts with the property’s purchase price, plus closing costs and improvements, minus land value. This adjusted cost basis is the foundation for depreciation.
• IRS Recovery Periods Apply: Residential rental properties are depreciated over 27.5 years (or 39 years for commercial), allowing owners to spread out the tax benefits across the property’s useful life.

One important concept to understand as a landlord is rental property depreciation. This is because it can help you minimize your expenses for an optimal ROI.

Essentially, rental property depreciation can allow you to deduct the cost of your real estate investment over time. As per the Internal Revenue Service (IRS), rental properties usually lose a certain portion of their value every year.

And for as long as you own the property, you can subtract the cost of that depreciation from your taxable income. And the impact of this is that it can help lower your taxes, thereby ensuring you keep more of your profits in your pockets.

In this guide from Abilene Leasing & Property Management will go over everything you need to know about rental property depreciation.

How Rental Property Depreciation Works

Buying a real estate investment often requires substantial amounts of money. But, in return for this initial cash outlay, the IRS has rules in place to ensure you offset that cost by factoring in the gradual decrease in the property’s value over time.

For real estate investments, the IRS allows investors to claim the cost of depreciation for up to 27.5 years. This period is spread over intervals of one year.

Depreciation on real estate investments occurs as a result of usage or decay over their lifespan. This reduces the asset’s value over time.

Who Can Claim Real Estate Depreciation

To qualify for real estate depreciation, the following are the requirements you’ll need to meet first.

• Own an investment property. This can be through paying off mortgage debt or outright ownership.
• Use the property for an income-producing activity, such as renting it out to obtain rent payments.
• The property must have a determinable useful life that exceeds at least one year.

How to Calculate Depreciation

Depreciation is one of the most valuable tax benefits available to rental property owners, but understanding how to calculate it correctly is key.

Under the IRS’s Modified Accelerated Cost Recovery System (MACRS), you must determine your property’s adjusted cost basis and then apply the appropriate recovery period to calculate the annual depreciation expense.

Step 1: Determine the Adjusted Cost Basis

The cost basis is not just the purchase price you paid for the property, it includes several other factors.

To calculate it, you will:

1. Start with the purchase price of the rental property.
2. Add allowable closing costs and settlement fees.
3. Add the cost of any capital improvements made to the property (for example, replacing a roof or adding a room).
4. Subtract the value of the land, since land does not depreciate.

Allowable closing costs usually include expenses such as:

• Legal fees
• Abstract fees
• Surveys
• Transfer taxes
• Recording fees
• Utility installation costs
• Title insurance

These costs add to the property’s value for depreciation purposes because they are directly tied to acquiring the property.

Example:
Suppose you purchased a rental property for $1,000,000. At closing, you paid $20,000 in additional settlement fees. Soon after, you invested $4,000 in a qualifying improvement. However, the land itself was valued at $60,000.

The calculation would look like this:
$1,000,000 + $20,000 + $4,000 – $60,000 = $964,000

This $964,000 figure is your adjusted cost basis and will be the number used to determine how much depreciation you can deduct each year.

Step 2: Calculate the Annual Depreciation Expense

Once you know the adjusted cost basis, the next step is to spread it out over the property’s “useful life” as defined by the IRS. For residential rental property, the recovery period is 27.5 years. For commercial property, the recovery period is typically 39 years.

There are two straightforward methods to determine your annual depreciation:

• Divide the adjusted cost basis by 27.5 (for residential).
• Multiply the adjusted cost basis by 3.636%.

Both methods yield the same result.

Example continued:
$964,000 ÷ 27.5 = $35,055 in annual depreciation.

That means each year, you could deduct $35,055 from your taxable rental income, reducing the amount of income subject to tax. This deduction does not involve any actual cash expense in that year, it is simply a paper expense that lowers your taxable income and improves your after-tax cash flow.

Why Depreciation Matters

Over time, depreciation can add up to hundreds of thousands of dollars in tax savings. For landlords with multiple rental properties, the deductions can make a substantial difference in profitability.

However, it’s also important to keep accurate records of your cost basis and improvements so that you can substantiate the amount claimed if ever audited by the IRS.

Bottom Line

As a savvy landlord, the goal of investing in a rental property is to minimize expenses and maximize ROI. And luckily for you, your property’s depreciation cost can help lower your tax bill every year, saving you money.

If you have a question or need expert property management services in the Big Country, look no further than Abilene Leasing & PM. Our full-service property management services can help you handle everything, from property marketing, to tenant screening, to rent collection, and everything in between.