What Is Depreciation?

depreciation refers to the concept that when you buy something, through use, wear and tear, weathering, and so on, it degrades. Much like your car loses its luster over time, so does your real estate.

This all sounds like a bummer, but there’s an upside! Depreciation allows for a tax benefit for that degradation. Any fixed asset or capital good with a finite usable lifespan can depreciate, including homes, automobiles, or investments. In some cases, intangible assets such as patents and copyrights can also depreciate.

Depreciation means real estate investors can write off the cost of a property or improvements over time, which can have years-long income tax benefits. Through depreciation write-offs, you can reduce your net income—in turn reducing your taxes. For tax purposes, the more rental properties the merrier… to an extent. Make sure to pay attention to how depreciation can hurt your portfolio, too.

What Is the Most Common Depreciation Method?

While there are a few different methods of depreciation, typically, it's determined in a linear fashion in what’s known as straight-line depreciation. Every year, a fixed amount is reduced from the asset’s value due to “wear and tear” until eventually the asset reaches a value of zero. The IRS maintains strict guidelines for how to depreciate real estate assets.
In order to be able to depreciate an asset following the straight line method, the following conditions must be met:

  • You must own the property outright
  • The useful life of the asset must be more than one year
  • It must be used for business or income-producing purposes.

Real estate property can meet condition number three you’re responsible for upkeep, repairs, maintenance, and taxes. But this only applies to structures above the ground. Land itself is not depreciable—it does not wear out or have a finite usable lifespan. The value of the asset remains steady during the sum of the years you own it. However, land improvements may depreciate, depending on what they are.

How Is Real Estate Depreciated?

Most real estate property depreciation is done under an intricate, Internal Revenue Service (IRS)-mandated system called Modified Accelerated Cost Recovery System (MACRS). These guidelines designate the depreciation rate, indicating the usable number of years for different fixed asset classes—which don’t necessarily coincide with the timespans most people would expect. That's the period of time over which the asset will depreciate. Here is the asset's useful life for a few different categories: 

  • Automobiles: 5 years
  • Office furniture: 7 years
  • Multi-unit housing: 27.5 years
  • Office buildings and commercial property structures: 39 years.

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.

  • You cannot depreciate land, so you (or your accountant) will need to establish what the structure is worth versus what the land is worth and only depreciate off the structure.
  • You can no longer depreciate a property if you move into it yourself.
  • You can no longer depreciate a property that’s been fully depreciated (meaning, you’ve depreciated it past 27.5 years).

When Can I Start Depreciating My Property?

You can start depreciating your place when it is ready for rental—not rented. If you buy a property and are ready to rent it day one—but it doesn’t end up renting until day 14—you can start depreciating it from day one.

How Much Is Depreciation? 

You can depreciate a property for 27.5 years. For every full year you own that property, you can depreciate it by 3.636 percent. So, if you buy a property that is worth $100K, after you subtract the land value, you can depreciate it by $3,636 per year.

If you purchase a property mid-year, for the first year, you have to depreciate via Schedule E on your tax return—which means lower depreciation as you get further into the year.

What is Depreciation Recapture?

If you sell an investment property for a profit, the IRS will come seeking to recapture the accumulated amount you have deducted (from ordinary income) for depreciation over the years since you purchased it. Because most depreciation on real estate is calculated in straight-line fashion, the IRS assumes this is the process the taxpayer used to depreciate the property.

Real estate assets are known as Section 1250 assets by the IRS. They get special tax treatment on asset gains upon sale. If a real estate investor sells a property for a profit (any amount over their adjusted cost basis), this profit is taxed at a rate of 25%, up to the total aggregate amount of depreciation claimed over the years of ownership. Any gains in excess of this aggregate depreciation taken by the investor is taxed at the prevailing long-term capital gains rate (a preferred, lower tax rate).

As an example, consider a property investor who buys a rental property fot $280,000. They claim depreciation of 3.36% per year as a deduction against ordinary income. If they hold the property for 10 years, the total accumulated depreciation would be:

($280,000 * .0336 * 10) = $94,080

If the property is sold for a profit of $100,000, the full $94,080 of depreciation is recaptured and taxed at 25%. The remaining profit of $5,920 is taxed at the long-term capital gains rate. 

Corporate Depreciation

In corporate accounting, depreciation for fixed assets is moved from the balance sheet—which states the remaining value of the property or good—to the income statement. Some state or federal guidelines mandate depreciation timetables, in addition to the MACRS requirements. Sometimes, owners can decide their own depreciation schedule. 

But any tangible, fixed asset with a usable life will depreciate over time, regardless of how the accounting is handled. Some larger companies only depreciate when the cost of the asset is more than $20,000; small business owners may depreciate smaller fixed assets, with an original cost of $10,000 or less. 

If an asset has any value left after all depreciation has been taken—i.e. the end of its estimated “usable life” has been reached—that amount is known as the salvage value. No more tax benefits can be accrued after this point. 

What Is Depreciation Used For?

Annual depreciation isn’t just behind-the-scenes accounting. It has real-world implications. A depreciated asset means lowered tax liability—you won’t pay property taxes on a dilapidated or damaged piece of property, for example. And each year a fixed asset is held, the owner receives tax deductions based on the amount of recorded depreciation. 

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Related terms
Appreciation
Appreciation is the increase in a home’s value over time. A home’s appreciation can be calculated based on the fair market value of comparable homes in the neighborhood of the property in question. Appreciation of a home can come through the natural appreciation of the value of the home over time or can be forced into the home through upgrades, remodels, or renovations that add value to the home.
Real Estate
Real estate refers to property containing land, buildings, or both.
Note
Mortgage notes are a written promise to repay a specified sum of money plus interest at a specified rate and length of time to fulfill the promise.