Rental Property Depreciation: How It Works and Why It Matters

Why depreciation matters more than most owners realize

Depreciation is one of the main tax advantages of rental property. The IRS lets owners deduct a portion of the building's cost each year as if it were wearing out, even when the property is appreciating in market value. That deduction can reduce taxable rental income without reducing cash flow.

• Depreciation is non-cash. The deduction reduces taxable income without affecting actual cash flow.
• It applies to the building structure and certain improvements only — never to the land.
• At sale, the IRS generally treats depreciation as allowed or allowable, which means skipped deductions can still create recapture.

The 27.5-year residential schedule

Residential rental property is depreciated straight-line over 27.5 years using the IRS Modified Accelerated Cost Recovery System (MACRS). Commercial property uses 39 years. The mid-month convention applies, meaning the first and last year are partial. A $250,000 residential rental with $200,000 attributed to the building generates roughly $7,272 per year in depreciation, which can offset that much of the rental net income.

How to calculate rental property depreciation

A simple rental property depreciation calculation starts with purchase price plus eligible closing costs and capital improvements, then subtracts land value because land is not depreciable. Divide the remaining residential building basis by 27.5 years to estimate annual straight-line depreciation before the mid-month convention adjustment.

Splitting basis between land and building

Only the building (not the land) is depreciable, so investors must split the purchase price into two pieces. The most common approach is to use the property tax assessor's land-to-building ratio. A typical residential property allocates 70% to 85% of the price to the building. Better allocation = more depreciation = lower tax bill, but the IRS expects a defensible methodology.

• Assessor's ratio is the simplest defensible method and is widely accepted.
• A real estate appraiser can produce a separate land valuation when assessor numbers seem unreasonable.
• A cost segregation study breaks the building into components with shorter recovery periods (5, 7, and 15 years), which dramatically increases early-year deductions on larger properties.

How depreciation hits Schedule E

Rental income, expenses, and depreciation flow through Schedule E on Form 1040. Rental losses are generally passive and limited to passive income, but active participants with adjusted gross income under $100,000 can deduct up to $25,000 of rental losses against other income. The deduction phases out between $100,000 and $150,000 of AGI. Real estate professionals (a strict IRS test) can deduct unlimited rental losses against any income.

Depreciation recapture: the catch at sale

When a depreciated rental is sold, the IRS recaptures the depreciation. The portion that came from the building itself (Section 1250 property) is taxed as unrecaptured Section 1250 gain at up to 25% federal. Components reclassified by a cost segregation study as Section 1245 personal property (5-, 7-, or 15-year items) are recaptured at ordinary income rates with no 25% cap, which can reach 37%. The remaining gain above original cost is taxed at long-term capital gains rates. A 1031 exchange can defer both the capital gain and the recapture by rolling the proceeds into a new investment property.