Real Estate Depreciation

Real Estate Depreciation is a tax deduction that allows real estate investors to recover the costs associated with purchasing and improving an income-producing property. Depreciation represents the gradual wear and tear of a property over time.

In the U.S., residential rental property is depreciated over a period of 27.5 years using the Modified Accelerated Cost Recovery System (MACRS), which is a method of depreciation that allows for greater deductions in the earlier years of ownership. Commercial property, on the other hand, is depreciated over a period of 39 years.

Here's a basic overview of how it works:

Determine Your Basis: The basis is typically the original purchase price of the property, plus any capital improvements (significant repairs or improvements that extend the useful life of the property), plus certain costs associated with the purchase, like legal fees, title fees, and recording fees.

Allocate the Basis: If you're depreciating a building and the land it sits on, you'll need to allocate the basis between the two, because only the building can be depreciated, not the land. This is typically done based on the proportion of the property's value that each component represents.

Calculate Annual Depreciation: Divide your basis for the building (not the land) by the appropriate recovery period (27.5 years for residential property or 39 years for commercial property). This will give you your annual depreciation expense, which you can deduct from your taxable income.

For example, let's say you purchase a residential rental property for $275,000, and $25,000 of that price is for the land. Your basis for the building would be $250,000, and your annual depreciation expense would be $250,000 / 27.5 = $9,091.

Depreciation is a non-cash expense, meaning it reduces your taxable income and therefore your tax bill, but it doesn't require any actual cash outlay during the year. It's one of the key tax benefits of real estate investing. However, when you sell the property, you may have to recapture and pay tax on the depreciation you've claimed.

The rules and calculations for depreciation can be complex, especially when it comes to things like improvements, conversions, or partial dispositions, so it's often a good idea to work with a tax professional or accountant who is familiar with real estate depreciation.