As a real estate investor, rental property depreciation is one of those terms you know you should understand—but put off learning about. Maybe you tucked it away in the back of your mind as a tax deduction you’ll address at another time. (You swear, you’ll figure it out another day.)
As it turns out, depreciation is probably a much simpler concept than you though. But before we dive in, let’s make one thing very clear: The best expert for your unique situation will be a local tax professional. There may be local or state regulations that complicate matters—and at the very least, you want to be certain you’re doing everything correctly.
What Is Depreciation?
When you buy an investment property, through use, wear and tear, weathering, and so on, it degrades—or depreciates. For example, your car loses its luster over time. You don’t value a 2008 Camry the same way you value a 2020 model. Same goes for real estate.
This all sounds like a bummer, but there’s an upside: Depreciation offers real estate tax benefits for that degradation. These can be big boons for real estate investors willing to invest time into a smart tax strategy.
What Can’t I Depreciate?
To be sure, there are rules when it comes to writing off depreciation. Here’s what does not qualify for a depreciation deduction on your tax return.
- Land: Dirt and rocks are still dirt and rocks 10 years down the line. Work with an accountant to determine what the structure is worth versus what the cost of the land and only depreciate the structure.
- Personal residences: You can no longer depreciate property if you move in yourself.
- Fully depreciated properties: After 27.5 years, you can no longer depreciate a residential property.
What Qualifies for Depreciation?
However, rental property owners find that most of their properties are depreciable. That’s because the primary rule for depreciation requires the property to be an investment or business—a.k.a., not your primary residence. You’ll need to be renting to a tenant, whether it be residential or commercial.
Here are the other rules:
- You must own it for at least one year.
- The property endures wear and tear.
- You actually own the property—you’re not renting it from another investor.
By these standards, pretty much all real estate investments should fit.
Calculating Straight-Line Depreciation
While several different methods exist, the appropriate depreciation method for you depends on the type of property and how old it is. The most common type is “straight-line depreciation,” which steadily depreciates the property over a number of years. This is the most general depreciation system, and is general the simplest to use.
Here’s how to calculate straight-line depreciation:
(asset purchase price – salvage value) / useful life
Let’s define those terms.
- Asset purchase price: This one’s easy. How much did you pay for the asset?
- Salvage value: Once the property is fully depreciated, how much do you think it will be worth?
- Useful life of the property: How long the property can be depreciated, also known as the “recovery period.” For real estate investors, the IRS has helpfully defined the “useful life” schedules:
- Residential rental property placed into service after December 31, 1986: 27.5 years
- Commercial rental property placed into service after December 31, 1986, but before May 13, 1993: 31.5 years
- Commercial rental property placed into service on or after May 13, 1993: 39 years
If none of those categories fit your property, check out the IRS’s seven property classes.
Generally, for every full year you own residential real estate, you can depreciate it by 3.636 percent. So, if you buy a property that is worth $100K, after you subtract the land value, annual depreciation will be $3,636 per year.
What about property acquired before 1986?
Investors that own property placed into service prior to December 31, 1986 generally use the Modified Accelerated Cost Recovery System (MACRS) for depreciation. This method allows an investor to take more depreciation in the early years of a property’s holding period. It can be a bit more complicated, so make sure to consult an accountant.
When Can I Start Depreciating My Property?
You can start depreciating your place when it is ready for rental—not when it is rented. If you buy a property and are ready to rent it day one, but it doesn’t end up renting for two weeks, you can start depreciating it from the start.
Investors shouldn’t forget about depreciation recapture, which happens when you sell a property that has been depreciated. Essentially, this allows the IRS to tax any portion of the sale of an asset previously used to offset taxable income. Generally, it’s taxed as ordinary income at a maximum rate of 25%.
Here’s an example. Let’s say you bought a two-bedroom rental five years ago, and spent $100,000 on improvements—making your depreciation expenses $3,636 per year, or $18,180 total. You recently sold the property for $500,000. However, due to the depreciation, your adjusted cost basis—your net cost post-depreciation—is $81,820. That means your total proceeds from the sale are $418,180.
The $18,180 you “gained” from depreciation will be taxed at the depreciation recapture rate. The rest of your proceeds will be taxed at the long-term capital gains rate—between 0% and 20%, depending on your income.
Writing Off Rental Property Depreciation on Your Taxes
Regardless of your income, tax law always allow you to use depreciation to offset your rental income. For example, let’s say your income was $1 million this year. You own rental real estate that had rental income and depreciation expenses—luckily, the depreciation expenses can be used to offset your rental income exactly the same as if your total income was $10,000 for the year. Some investors worry that higher incomes limit depreciation tax advantages, but this isn’t necessarily true. There is never a limitation of how much depreciation you can use to offset rental income.
First, let’s discuss expenses, such as property taxes, insurance, management fees, and repairs. You can always use your rental expenses to offset your rental income, and this is true regardless of whether you make $10,000 or $1 million.
Now, what happens if you have an overall net loss on your rentals? Let’s say you have a cash-flow-positive rental property that provides you with $5,000 per year. By using tax strategies to maximize your write offs, repairs, and depreciation expenses, you end up with a net tax loss of $2,000. The question is whether the $2,000 excess loss can be used to offset your other income (i.e.: W-2 income).
Potential tax limitations
Here is where the potential limitations come in. The IRS has a rule that if you are not a real estate professional (i.e., someone who spends more time in real estate than your other job or business), then you can use up to $25,000 of your excess rental losses to offset your other income—if your income is under $100,000.
If your income is between $100,000 and $150,000, then you can still use your real estate losses to offset your other income. The amount you can use just may be limited.
Once your income is above $150,000, then you cannot use the excess losses to offset your other income. Those losses can offset future rental income.
Depreciation and taxes: An example
Let’s take Adam as an example. He works at a W-2 job, where he makes $40,000 per year. With rental income of $20,000 and rental expenses of $30,000, Adam has a net rental loss of $10,000. Since his income is under the IRS threshold, he can use the $10,000 of excess losses to offset his W-2 income.
If Adam makes $200,000, he cannot use the $10,000 excess loss to offset his W-2 income. Important note: We are not saying Adam can’t write off his depreciation or expenses—he certainly can! He can use his depreciation and expenses to reduce the entire $20,000 of rental income. However, he cannot use the excess $10,000 to offset his W-2.
Adam pays zero taxes on the $20,000 of rental income he received during the year, regardless of how much money he makes through his W-2 job. Compare that to a CD: If, in the unlikely event that Adam made interest income of $20,000 from that bank CD, he would have had to pay taxes on that entire amount.
The same goes for capital gains. Had Adam sold stocks and made $20,000, he would generally have to pay taxes on that $20,000 gain.
Reducing income taxes using capital gains
If you make more than $150,000 a year, there are still ways to take advantage of depreciation. You can apply unused depreciation to a particular property you’ve sold, producing a capital gain. Though you’ll owe capital gains tax, the property’s unused depreciation will now break the IRS shackles and rush to the aid of that year’s ordinary income.
Let’s say Adam has a W-2 job that pays $250,000. He sells a rental property that generates an impressive capital gain. However, during all those years when he couldn’t use depreciation to offset his income, he accumulated $100,000 dollars of unused depreciation.
That $100,000 gets pushed immediately over to their job income, as the property producing said depreciation has been sold. It essentially “shelters”’ that investor by lowering the amount of taxable income and offsetting the capital gains tax.
Regardless of your income, owning real estate could be an efficient investment for tax purposes. There are no limits to expenses, and depreciation can be used to offset rental income. In fact, if Adam owned three properties—some profitable and some not-so-profitable—the expenses and depreciation from one rental can be used to offset the income from another rental.
What other questions do you have about depreciation?
Let’s discuss in the comment section.