One of the biggest advantages of owning real estate is the favorable treatment real estate investors receive in the tax code. Simply put, the government wants its citizens to invest in real estate and uses the tax code to encourage this. Though the government does what it can to put incentives in the right place, it’s ultimately up to you to learn how tax laws work and apply them skillfully to your own situation.
In particular, IRS rules for depreciation deductions on rental property go a long way towards reducing your annual tax bill. Depreciation deductions can be worth tens of thousands of dollars per year.
Today, we’ll look at the two methods of depreciation used by the IRS for rental real estate, giving you the tools to maximize your deductions and take full advantage of real estate ownership.
Put simply, depreciation is an asset’s loss of value over time due to aging, wear and tear, or obsolescence.
Nearly everything you own depreciates. If you buy an iPhone, then go to sell it in a year, you might be able to get half of what you paid. If you buy a brand-new car, the moment you drive it off the lot it will lose thousands of dollars in value.
We understand intuitively that, as things age, wear out, or become obsolete, their value declines. This is true of phones, cars, and of real estate too.
“But wait,” you’re thinking. “I thought the whole point of owning real estate is that it goes up in value. Now you’re telling me that real estate depreciates? What gives?”
Well, land does generally go up in value. This is barring any extreme events (think Chernobyl) that make land highly undesirable and cause its value to plummet. Other than that, land values in any area that is at least somewhat desirable tend to rise over time.
However, the buildings built on the land do depreciate. This depreciation may be harder to notice than it would be with, say, an iPhone, because the loss of value takes place over decades, not months or years. Think about it—the “useful life” of a house is at least 30 years, and usually longer.
Fixtures (i.e., permanently affixed personal property, like ceiling fans, towel racks, landscaping, smoke detectors) also depreciate, and usually at a faster rate than buildings.
To summarize: Buildings depreciate slowly, fixtures depreciate more quickly, and land tends to go up in value.
So, at any given time, there are components of the property that are losing value, and components of the property that are gaining value. When a property’s value goes up, it is because the land value and overall desirability of the property have outpaced depreciation, resulting in a net gain in value.
Depreciation and Real Estate Taxes
For tax purposes, the IRS permits owners of rental properties to deduct estimated depreciation on their taxes every year. This deduction is a huge benefit to real estate investors and is just one more reason why real estate is such a desirable asset class to own.
Tip: Depreciation deductions as discussed in this article do not apply to a personal residence. If you rent out a portion of your personal residence, depreciation deductions only apply to that portion used for rental purposes. These situations can get complex and are best handled with the help of a CPA with a strong background in real estate investments.
Per IRS regulations, certain components of an investment property can be depreciated on your taxes. On their taxes, owners of residential property can depreciate:
- Any other structural components
- Office equipment and vehicles used in the operation of a rental property business
The only component you are not permitted to depreciate on your taxes is the land.
Most tax deductions are tied to an expense. This means that you need to spend money to save money. For example, you spend $500 on web hosting, then get to deduct $500 from your taxable income.
However, a big benefit of depreciation is that it is a phantom expense. This means that you get to take a depreciation deduction without actually spending money. It’s like making money out of thin air. Depending on the cost of your property, these deductions can be worth tens of thousands of dollars per year.
For tax purposes, you calculate depreciation deductions based on IRS rules, which will be discussed in detail in the next section. It’s important to understand that these IRS rules do not reflect an actual loss of value. It’s best to think of these formulas as accounting math that allows you to save a lot of money on your taxes, rather than a literal loss of value.
For example, the IRS permits you to deduct about 3% of the cost of your improvements every year for 27.5 years. Does this mean that the improvements on your property literally lose 3% in value every year, and are worthless at the end of the 27.5 years? No! This is just a simplified, standardized way for the IRS to account for the fact that improvements lose value over time. Remember, even as structures slowly lose their value, the overall value of real estate tends to go up.
Tip: It’s important to understand the distinction between “book value” and “market value.” For our purposes, “book value” will refer to what the IRS considers the asset to be worth, and therefore how much you can deduct on your taxes. The “market value” refers to the probable value you’d get if listing the asset on an open market. Just because you’ve depreciated an asset to zero on your taxes, does not necessarily mean the asset is literally worth zero. For example, if you purchase a computer for use in your real estate investing business, the IRS permits you to depreciate that computer to zero over five years. So, in five years, the book value of the computer is zero. However, it is unlikely that the market value of the computer would also be zero after five years. The computer will definitely depreciate, but is unlikely to become worthless.
Depending on the situation, the IRS specifies two different methods of depreciation to be used. The first method is straight-line depreciation. With this method, you are given a “recovery period” (you can also think of this as the “useful life”) for a certain type of asset. A fixed annual amount of depreciation is calculated such that the book value of the asset is zero at the end of the recovery period.
Looking at the straight-line method mathematically makes it a bit easier to understand. Let’s work through an example:
Suppose we purchase a residential rental building. Of the $370,000 purchase price, $275,000 is attributable to the physical building. (The remainder, $95,000, is land cost, which is not depreciated.) $275,000 is our “cost basis” for the building. For buildings, the IRS gives us a recovery period of 27.5 years. To figure out how much depreciation we can take every year, we divide the cost basis by the recovery period.
$275,000/27.5 = $10,000 Depreciation Per Year
Another way to calculate this is to divide 1 by the recovery period, giving us a depreciation rate that can then be used to calculate annual deductions.
Depreciation Rate = 1/27.5 = 3.64%.
Then, we multiply our depreciation rate by our cost basis.
$275,000*3.64% = $10,000 Depreciation Per Year
If we create a graph that shows the asset’s book value over time, it’s easy to see why this is called straight-line depreciation:
As you can see, the fixed $10,000 reduction in book value every year results in a straight line, taking the asset’s value from $275,000 all the way to zero at a fixed rate over 27.5 years.
Declining Balance Depreciation
Declining balance depreciation is a form of accelerated depreciation permitted by the IRS in certain situations. With declining balance depreciation, an asset’s book value will decrease at a high rate in the first few years of ownership. In later years, the rate of depreciation slows.
A graph of a declining balance scenario makes it easy to visualize the advantages of accelerated depreciation.
Another way to compare the two methods is to look at the amount of depreciation you get to take per-year. Here’s how that looks side-by-side for the straight-line method and the declining balance method:
As you can see, with the declining balance method you can take much more depreciation upfront. This translates to a significant tax savings.
Tip: Per IRS rules, you will switch from declining balance depreciation to straight-line depreciation in the first year that the deduction given by the straight-line method is greater than the deduction given by the declining balance method. Looking at both graphs, you should be able to see the point where the curve straightens out, and the switch is made from declining balance to straight-line depreciation until the asset’s value reaches zero.
For residential rental property, the IRS uses two forms of declining balance depreciation—200% declining balance and 150% declining balance. Two hundred percent declining balance is also called “double declining balance.”
Let’s look at an example where we calculate depreciation using the 200% declining balance method. We’ll use an asset initially valued at $15,000, and a recovery period of 15 years. First, we need to find a depreciation rate.
Depreciation Rate = 1/Recovery Period
Let’s suppose our recovery period is 15 years. In this case, our depreciation rate will be 1/15 = 6.67%.
Next, double the depreciation rate to get 13.33%. This is the rate we will use to find depreciation with the 200% declining balance method.
We also need to know the amount of annual depreciation we would take if using the straight-line method. We will find this by dividing our cost basis by the recovery period. In this case, it would be $15,000/15 years = $1,000/year.
Next, let’s make a table that shows how much depreciation we can take each year. The easiest way to do this is in Excel. To start, create something that looks like this:
To fill in the table, we’ll start by calculating the amount of depreciation for Year 1. This will be our starting balance ($15,000) multiplied by our doubled depreciation rate (13.33%). Type “=B2*0.1333” into cell C2 and press enter. This should result in a value of $1999.50.
Next, we need to calculate the book value of the asset in Year 2. We’ll find this by subtracting Year 1 depreciation from the Year 1 book value. Type “=B2-C2” into cell B3 and press enter. This should result in a value of $13,000.50.
Now, we repeat the process. To find depreciation in Year 2, take 13.33% of the value in B3, and enter it in C3. Continue this until you reach a value in column C that is less than the amount of depreciation you’d take with the straight-line method ($1,000). This should happen in Year 6.
Once the amount of depreciation you are allowed to take using the 200% declining balance method goes below the amount you’d be able to take with the straight-line method, you switch to the straight-line method.
Finally, once the book value of the asset drops below $1,000, you simply subtract the remaining balance as depreciation. This will give a zero balance in the following year. The final result will look like this:
Note that we are able to take significantly more depreciation in the early years than we would using the straight-line method. Also notice that in spite of our 15-year recovery period, the 200% declining balance method causes us to finish depreciating this asset in year 13, two years earlier than we would with straight-line depreciation. To highlight the differences between the straight-line method and the 200% declining balance method, here’s how the two methods look side by side:
The 150% declining balance method works in exactly the same way, except that instead of multiplying your depreciation rate by 2 (200%), you multiply it by 1.5 (150%).
The simplest way to calculate depreciation deductions for your property is to use the straight-line method with a recovery period of 27.5 years and apply this to the entire non-land cost of your property. However, this is not the most effective method of calculating depreciation. While it is simple and convenient, you will likely leave a substantial amount of money on the table if this is how you calculate your depreciation.
Savvy real estate investors instead use cost segregation. Cost segregation is the process of separating real property into its constituent assets, which are then depreciated at different rates according to IRS guidelines. This is advantageous because many types of assets within real estate have shorter recovery periods and/or permit accelerated depreciation, allowing investors to maximize deductions in their first few years of ownership. Remember the golden rule: take as much depreciation as you can, as early as you can.
The IRS provides a range of “recovery periods” for different types of assets. You can think of this as an asset’s IRS-defined useful life. The different recovery periods available to owners of short-term rentals are as follows:
- 5 years for computers, office equipment, appliances, carpets, and furniture.
- 15 years for “roads, shrubbery, and fences.”
- 27.5 years for residential property (buildings or structures).
- 39 years for commercial property (buildings or structures).
- 7 years for “any property that doesn’t have a class life and that hasn’t been designated by law as being in any other class.”
If you do some research, you may find that a professionally done cost segmentation can cost over $10,000 and requires the help of an engineer. You can go down that road if you want, but it’s probably overkill for most short-term rental investors. Instead, just keep good records and hire a real estate-focused CPA to help you organize your property’s constituent assets into 5-, 7-, 15-, and 27.5-year property, then calculate the corresponding deductions.
Keep in mind that any upgrades to the property will also be depreciable. So if you’re considering new carpet, new floors, or new windows, keep in mind that you’ll get to depreciate these upgrades and lower your tax bill in the process.
Also, note that a property’s assessed value for tax purposes doesn’t always correlate with the property’s market value. As we know, real estate prices tend to go up. That’s a big part of why we’re in the investing game.
When it’s time to sell your rental investment property, you will most likely pay two kinds of taxes: capital gains tax and depreciation recapture. If you’ve read our other article on taxes, you’ll probably already know a bit about capital gains and how they are taxed at a lower rate than ordinary income.
Capital gains are simple to figure out for investments like stocks. If you buy a stock for $100 and sell it for $150, you have a gain of $50 which is taxed at a capital gains rate. It gets trickier when you’re dealing with real estate because capital gains and depreciation must be taken into account. This is because when you sell, you are taxed on your total amount of depreciation deductions at your ordinary income tax rate. This is called “depreciation recapture.” Let’s look at an example of depreciation recapture in action:
You purchase an investment property for $200,000. Over the next ten years, you deduct $70,000 of depreciation on your taxes. Then, you sell the property for $250,000.
- Your cost basis is $200,000. This is what you originally paid for the investment.
- Your adjusted cost basis is $130,000. This is the original cost basis minus accumulated depreciation.
- You have a capital gain of $50,000. This is your sale price minus your purchase price ($250,000-$200,000)
- You have accumulated depreciation of $70,000. This is the total amount of depreciation you deducted on your taxes while you owned the property.
To figure out the amount of tax you owe for depreciation recapture, multiply the amount of accumulated depreciation by your ordinary income tax rate:
Depreciation Recapture Tax = Accumulated Depreciation * Ordinary Income Tax Rate
If your ordinary income tax rate is 25%, then the tax owed on recaptured depreciation will be $70,000 * 25% = $17,500.
To figure out the amount of capital gains tax you owe, multiply your capital by your capital gains tax rate.
Capital Gains Tax = Capital Gain * Capital Gains Tax Rate
If your capital gains tax rate is 15%, then your capital gains tax will be $50,000 * 15% = $7,500.
Tip: Depreciation recapture is generally taxed at your ordinary income tax rate, but there are some important specifics outlined in Section 1250 of the IRS Code. As for the rate applied to your capital gains, this is variable based on your income. The IRS provides more info on capital gains tax rates here.
Don’t try to avoid depreciation recapture by not deducting depreciation every year. The IRS will charge you tax on the amount that you could have taken as depreciation even if you didn’t take it. Also, depreciation is overall a good thing—it is foolish not to take advantage of it.
In a nutshell, deducting depreciation on your taxes doesn’t permanently save you from having to pay tax on this money. Rather, it delays the time you will pay this tax to when you sell your property. Even though you still pay tax on your depreciation eventually, it is a huge advantage to be able to take depreciation.
Again, this is due to the time value of money. You’d rather have $1,000 today than $1,000 in five years. The more cash you have on hand to reinvest today, the better.
Big Tip: If you use a 1031-Exchange you can sell one property, use the proceeds to buy a new property, and avoid paying capital gains AND depreciation recapture.
It Behooves You to Get a CPA
Despite the level of detail in this article, most of the examples we looked at would still be considered oversimplified by a real estate tax specialist. Tax laws are complicated and ever-changing. You need to stay attuned to updates from the IRS and make sure your filing and record-keeping are in accordance with their requirements.
Remember to keep excellent track of your expenses, hanging onto receipts, and do the work to figure out which expenses can be fully deducted in a single year, and which can be depreciated over multiple years. If accelerated depreciation is available for a certain cost, you should segment out that cost and take advantage of accelerated depreciation.
If you try to get organized to file your taxes yourself, you’ll quickly see what we’re talking about. Figuring out what you owe is difficult in any year, but becomes especially complicated in years where you are selling one or more of your properties. Working with a professional will simplify your role in the process, allowing you to maximize your tax savings without spending days reading the fine print of the tax code. And, perhaps most importantly, a tax professional can help you avoid serious mistakes that could result in an audit.