Depreciation (Real Estate)
Depreciation is a non-cash tax deduction that lets rental property owners write off the cost of the building over 27.5 years. It reduces taxable income without reducing actual cash flow — which is why depreciation is often described as the single best tax advantage of real estate investing. A property earning $8,000/year in cash flow may owe zero tax because depreciation offsets the income on paper.
The core concept: buildings wear out, land does not
The IRS treats buildings as wasting assets — they physically deteriorate over time. Land does not depreciate. So when you buy a rental property, you allocate the purchase price between the building (depreciable) and the land (not depreciable).
| Component | Depreciable? | Useful life (residential) |
|---|---|---|
| Building and structure | Yes | 27.5 years |
| Land | No | — |
| Personal property (appliances, fixtures) | Yes | 5–7 years (cost segregation) |
| Land improvements (paving, fencing) | Yes | 15 years |
The formula
| Input | Notes |
|---|---|
| Purchase price | What you paid, plus acquisition closing costs |
| Land value | Typically 10–20% of purchase price; use county assessor's land/improvement split as a starting point |
| 27.5 | IRS useful life for residential rental property |
Worked example
$160,000 rental property. County assessor values the land at $20,000 (12.5% of purchase price).
| Calculation | Amount |
|---|---|
| Purchase price | $160,000 |
| Land value | − $20,000 |
| Depreciable basis | $140,000 |
| Annual depreciation ($140,000 ÷ 27.5) | $5,091/year |
| Monthly depreciation | $424/month |
Impact on taxable income:
| Item | Amount |
|---|---|
| Rental income | $21,600 |
| Operating expenses | − $8,324 |
| Mortgage interest (approx. Year 1) | − $8,380 |
| Taxable income before depreciation | $4,896 |
| Depreciation | − $5,091 |
| Taxable income after depreciation | − $195 (paper loss) |
| Actual cash flow | $1,960 (positive) |
The property produces $1,960 in real cash flow but shows a $195 paper loss for tax purposes. That paper loss may offset other income, depending on your income level and investor classification.
Passive activity rules and income limits
Depreciation deductions from rental properties are "passive losses." They generally offset only passive income. However:
| Situation | Ability to deduct losses |
|---|---|
| Active participation + AGI ≤ $100,000 | Up to $25,000 of passive losses against ordinary income |
| Active participation + AGI $100K–$150K | Phased out proportionally |
| AGI above $150,000 | Losses suspended until sale or offset by other passive income |
| Real Estate Professional status | Unlimited deduction against ordinary income |
Suspended losses carry forward and reduce gain at the time of sale.
Depreciation recapture: the deferred tax bill
When you sell a property, the IRS recaptures the depreciation you took — taxing it at 25% (depreciation recapture rate), not your ordinary income rate. This is unavoidable unless you defer via a 1031 exchange.
| Item | Amount |
|---|---|
| Depreciation taken over 5-year hold ($5,091 × 5) | $25,455 |
| Depreciation recapture tax (25%) | $6,364 |
This is a real future cost. Factor it into your projected sale economics.
Cost segregation: accelerating depreciation
Cost segregation is an engineering study that reclassifies components of a building from 27.5-year (or 39-year for commercial) to 5-, 7-, or 15-year property, dramatically front-loading the tax benefit.
| Component reclassified | Accelerated life |
|---|---|
| Appliances, carpeting, fixtures | 5 years |
| Land improvements (landscaping, parking) | 15 years |
| Non-structural interior components | 7 years |
Combined with bonus depreciation (currently being phased down from 100% introduced in 2017), cost segregation can produce very large deductions in Year 1. It typically makes economic sense for properties with $500,000+ in depreciable basis.
Common mistakes
1. Forgetting to depreciate at all. Some new investors don't claim depreciation because they don't know about it. The IRS expects you to recapture it when you sell regardless of whether you claimed it. You lose the benefit without avoiding the cost.
2. Using the full purchase price as the depreciable basis. You cannot depreciate land. Using the full purchase price overstates your deductions, which the IRS will correct — potentially with penalties and interest.
3. Ignoring depreciation in sale projections. Many investors calculate expected profit at sale without modeling depreciation recapture tax. This makes the projected sale proceeds look higher than they actually are after-tax.
4. Not tracking capital improvements. Capital improvements (new roof, HVAC replacement) are added to the depreciable basis and depreciated separately — not expensed in the year spent. Keeping clear records is critical.
Frequently asked questions
Does depreciation reduce my actual cash flow? No — depreciation is a non-cash deduction. You get the tax benefit without writing a check. This is what makes it uniquely valuable compared to most deductions.
Can I depreciate a primary residence? Only if it is used as a rental or business property. A personal residence does not qualify for depreciation while you live in it.
What happens to suspended passive losses when I sell? They are released and can offset the gain on sale. If you have $30,000 in suspended passive losses and a $50,000 gain, you pay tax on only $20,000 (simplified).
How do I find my land value for the depreciation calculation? The county tax assessor's property record typically shows a land value and improvement value breakdown. You can also have a qualified appraiser allocate the purchase price. Using the assessor's ratio as a starting point is common.
Depreciation rules, passive activity limits, and depreciation recapture are complex and subject to change. This page is educational only and does not constitute tax advice. Consult a CPA or tax professional for your specific situation.