Real estate depreciation is a cornerstone concept in real estate investment and tax planning. Understanding how it works—and how to maximize its benefits—can significantly impact your bottom line. In this guide, we’ll break down what real estate depreciation is, how it’s calculated, and how investors can leverage it to optimize their tax positions.Â
What Is Real Estate Depreciation?
Real estate depreciation refers to the process of deducting the cost of a tangible property over its useful life. These deductions account for the property’s wear and tear, deterioration, or obsolescence over time. When referring to tax depreciation, the IRS allows property owners to recover the cost of income-producing real estate (excluding land) through annual tax deductions. Tax Depreciation is not a reflection of the property’s market value but rather a tax strategy to allocate the investment cost of the building over a specified period.
Eligible Properties for Depreciation
To qualify for depreciation, the property must meet the following criteria:
- You own the property (even if it’s subject to a mortgage)
- The property produces income (such as rental or business use)
- It has a determinable useful life
- The property is expected to last more than one year
Importantly, land is not depreciable, though land improvements (e.g., landscaping, fencing, parking lots) often are.
Useful Life of Property: Residential vs. Commercial
The IRS defines the recovery periods for different types of real estate:
- Residential rental property: 27.5 years
- Commercial property: 39 years
Depreciation typically uses the Modified Accelerated Cost Recovery System (MACRS), which calculates deductions using a straight-line method over these timelines.
How to Calculate Real Estate Depreciation
The basic formula for depreciation is:
Depreciable Basis ÷ Recovery Period = Annual Depreciation Deduction
Here’s how it works:
- Determine the depreciable basis: Start with the purchase price, then allocate between the building and land. Only the building portion is depreciable.
- Apply the appropriate recovery period: Use 27.5 or 39 years, depending on the property type.
- Deduct annually: Apply depreciation deductions each year you hold the property for income-generating use.
Example: If you purchase a residential rental property for $500,000, and $400,000 is allocated to the building, your annual depreciation deduction is approximately:
$400,000 ÷ 27.5 = $14,545.45 per year
Advanced Depreciation Strategies
1. Cost Segregation
A cost segregation study breaks out building components into shorter recovery periods (e.g., 5, 7, or 15 years), allowing for accelerated depreciation. This can lead to significant tax savings in the early years of ownership.
2. Bonus Depreciation
Bonus depreciation enables property owners to immediately deduct a large portion of qualifying assets with shorter useful lives (typically under 20 years). This incentive is particularly beneficial after a cost segregation study has identified eligible assets.
3. Section 179D Deduction
While traditionally geared toward equipment and tangible personal property, Section 179D can sometimes apply to real estate improvements depending on the asset and use.
Real Estate Depreciation and Recapture
When you sell a property, depreciation taken over the years may be subject to depreciation recapture, which is taxed at a maximum rate of 25%. This makes it essential to track depreciation deductions carefully and work with a tax advisor when planning an exit strategy.
Documentation and IRS Compliance
Accurate documentation is essential. Property owners should maintain:
- Purchase documents with land/building allocations
- Cost segregation reports (if applicable)
- Detailed depreciation schedules
- IRS Form 4562 (Depreciation and Amortization)
Real estate depreciation offers a powerful way to reduce taxable income and increase cash flow. However, maximizing its benefits requires an understanding of the rules, the ability to identify qualifying assets, and a long-term tax strategy.
Partner with Real Estate Tax Experts
If you’re looking to maximize real estate depreciation strategies like cost segregation or bonus depreciation, working with experienced professionals is key. Source Advisors specializes in engineering-based cost segregation studies that unlock accelerated deductions and long-term value.
