How to Calculate Rental Property Depreciation

Understanding how to calculate rental property depreciation is essential for any real estate investor looking to maximize their tax savings. Depreciation allows property owners to recover the cost of wear and tear on a property over time, effectively lowering their taxable income.

However, many new investors find the process confusing, especially when it comes to IRS rules and the various methods available. In this guide, we’ll break down everything you need to know about rental property depreciation, from the basic calculations to the best strategies for boosting your real estate investment returns.

What is Rental Property Depreciation?

Rental property depreciation is a financial principle that owners use to reflect the incremental decline of property value over time. The method allows owners to make gradual tax deductions for value loss during the useful life of property. 

Depreciation helps owners defray some of the cost of property maintenance and improvements through tax relief. It doesn’t reflect the actual quality of the properties in question. Instead, depreciation addresses the understanding of loss in market value over long periods.

Understanding the Basics of Depreciation

Calculating all the variables may take some time, but the framework of rental property depreciation is fairly simple:

• Calculate the initial cost spent to buy the building itself by taking the total price you paid and subtracting the land value.
• Determine how long the property is expected to last, known as the useful life.
• Spread the initial cost over the useful life span to set an annual depreciation value.
• Deduct the annual depreciation from your taxable income when you file your tax return.

The IRS has established some standards for these calculations for real property: an average useful life span of 27.5 years and an annual depreciation rate of 3.636%.

There are two approaches to calculating annual deductions in rental property depreciation. One is the straight-line approach, in which the initial cost is spread evenly throughout the useful life span. The annual deduction will be the same from year to year.

The other method is accelerating the depreciation. This strategy allows an owner to take a bigger deduction right now. Future deduction rates then progressively get smaller by the year until the end of the useful life term.

Property owners use rental property depreciation to free up cash flow. By deducting the annual depreciation amount from their taxes, they passively keep a little more money to use on expenses or improvements. Their tax payouts are reduced, too.

Rental property depreciation only applies to the declining value of buildings on the property — not the land itself. Land isn’t subject to normal wear and tear like physical structures are.

Steps for Determining a Rental Property’s Depreciation

Here’s a step-by-step guide on how to calculate rental property depreciation.

Determining the Useful Life of a Rental Property

The IRS has established a 27.5-year standard for a rental property’s useful life. For some buildings, however, a few factors can affect this standard:

• Wear and tear: How building components deteriorate over long periods of use
• Construction material: How specific building components endure exposure to elements
• Maintenance: How regularly and thoroughly building parts are cared for
• Usage: How frequently and heavily specific components are used
• Local climate: How environmental conditions affect outside building materials
• Compliance: How regulations and building codes impact construction and renovations

Some examples demonstrate how these factors affect property value. For one, buildings made of brick are more weather-resistant than those made from wood or vinyl siding. Brick, therefore, takes longer to undergo wear and tear, extending its useful life.

Technological development can have an impact on useful life calculations as well. For example, appliances that meet ENERGY STAR certification standards last longer than older models. 

Calculating the Initial Basis and Land Value

Establishing an initial value — or cost basis — is the next step in determining depreciation. It helps to calculate typical expenses and set the property’s true value. This, in turn, determines the annual amount owners can deduct from their taxes.

A rental property’s initial cost basis takes all costs of the original acquisition into account. The total includes more than just the purchase price the owner paid. It also includes closing costs, legal fees, improvement costs, real estate commission and professional fees.

After arriving at this cost basis, owners deduct the land value separate from the building. The final cost basis represents the total value of the building isolated from the land.

Applying the Depreciation Formula

The formula for calculating depreciation is simple: divide the initial cost basis by the useful life.

Say you have a property that costs you $300,000 to acquire after renovations, closing costs and other expenses. Apart from the building, the land value is $50,000, so you subtract that amount from the total cost. You’re left with an initial basis of $250,000.

Then, divide the basis by the useful life span — the IRS standard of 27.5 years — to determine the amount of annual depreciation:

$250,000 / 27.5 = $9,090.90

Deducting Rental Property Depreciation

The above example reflects the straight-line method of deducting depreciation from taxes. The amount does not change from year to year. Another method, however, allows for more varied annual deductions.

This system is called the Modified Accelerated Cost Recovery System (MACRS). This strategy allows owners to frontload their annual depreciation. That means you could deduct a higher amount in your earliest period of ownership and then progressively make smaller deductions year after year.

Besides having different payout amounts, the MACRS method requires additional consultation of IRS Publication 946 (How to Depreciate Property). You’ll use this regularly updated table to find out what rates are appropriate for your property.

You or your accountant report depreciation using IRS Schedule E (Supplemental Income and Loss) Form 1040, which has a section accounting for Depreciation and Amortization.

Strategies to Maximize Depreciation Benefits

There are a few ways to get the most out of your annual rental depreciation, including some that can increase the amount of allowed deductions.

Bonus Depreciation

This strategy allows you to deduct certain renovations from the relevant year’s taxes rather than accounting for them at purchase. For example, if you buy a rental property in 2023, and you set $30,000 aside for electrical upgrades but don’t plan on making those upgrades until 2026, you can deduct that $30,000 in total in 2026.

Section 179 Deductions

Section 179 deductions are similar to bonus deductions but come with some limitations, like annual limits on deductions. They typically come with phase-out thresholds. If you exceed a given amount in renovation costs, your tax benefits decrease.

Section 179 rules make deductions easier to manage. Many accountants believe they suit items with shorter lifespans, like carpets and appliances.

Consistent Renovations

Making regular and consistent upgrades to your rental property extends its useful life. The more you can renovate, the more you may be able to deduct for depreciation. Ensure you’re up on the latest tax code revisions to ensure compliance.

Work With a Tax Consultant

The simplest way to maximize your depreciation deductions is to collaborate with someone who’s an expert in finances, specifically taxes. A qualified tax accountant or consultant works with you to ensure you follow the right guidelines.

Get the Facts on Rental Property Depreciation

Knowing how to calculate rental property depreciation can be the key step in freeing up cash flow and lessening your tax burden. As long as you adhere to local and state regulations and plan carefully, you can realize significant advantages as a rental property owner.

Frequently Asked Questions