How Does Depreciation Work on a Rental Property?

Owning rental property can provide ongoing income and long-term investment potential, but it also introduces important tax considerations. One of the most significant is depreciation, which generally allows property owners to recover the cost of certain income-producing property over time.

Understanding how depreciation works can help real estate investors maintain accurate records, prepare for tax filings, and better understand the tax consequences of eventually selling a property.

What Is Rental Property Depreciation?

Depreciation is a tax deduction that generally allows you to recover the cost of qualifying property over its useful life.

With rental real estate, the property may continue to have significant market value—or even increase in value—while depreciation is being claimed for tax purposes.

This makes depreciation different from simply measuring whether a property's market value has decreased.

What Part of a Rental Property Can Be Depreciated?

Generally, the building and certain improvements may be depreciable.

The land itself is not depreciated.

For example, if you purchase a rental property that includes both a building and land, the purchase price generally needs to be allocated between the two.

Only the portion attributable to the depreciable property is used when calculating building depreciation.

What Is the Depreciable Basis?

Your basis is an important part of determining depreciation.

The starting basis generally includes the amount paid for the property, but certain acquisition costs and subsequent improvements may also affect the property's basis.

Because land is not depreciable, the appropriate portion attributable to land generally must be removed when determining the depreciable basis of the building.

Maintaining accurate records from the time you purchase the property is therefore important.

When Does Depreciation Begin?

Depreciation generally begins when the property is placed in service as a rental.

This is not necessarily the same day you purchase the property.

For example, you might purchase a property and spend several months renovating it before making it available for rent. Determining when the property is actually placed in service can affect when depreciation begins.

How Long Is Residential Rental Property Depreciated?

Under current federal tax rules, residential rental buildings are generally depreciated over 27.5 years using the applicable depreciation method and convention.

Different types of property can have different recovery periods.

Furniture, appliances, equipment, improvements, and other assets associated with a rental property may therefore be treated differently from the building itself.

What About Improvements?

Significant improvements generally need to be distinguished from ordinary repairs and maintenance.

A repair may potentially be deductible as a current expense when applicable requirements are satisfied, while an improvement may need to be capitalized and depreciated over time.

Examples could include certain major renovations, additions, or substantial improvements to the property.

Correctly distinguishing between repairs and capital improvements can be an important part of rental property accounting.

Can Appliances and Other Assets Be Depreciated Separately?

Potentially, yes.

A rental property may include assets other than the building itself, such as appliances, furniture, equipment, or certain improvements.

These assets may have different depreciation periods and treatment.

Keeping detailed records of major purchases and improvements can help ensure they are properly accounted for.

How Does Depreciation Affect Rental Income?

Depreciation can reduce taxable rental income even though it does not necessarily involve a new cash payment each year.

For example, a property may generate positive cash flow while depreciation and other allowable expenses reduce the amount of taxable rental income.

However, the ability to currently deduct rental losses can depend on passive activity rules and the taxpayer's individual circumstances.

What Happens If the Property Increases in Value?

Market appreciation does not generally prevent depreciation deductions on qualifying rental property.

A building could increase substantially in market value while depreciation continues to be calculated based on its tax basis and applicable depreciation rules.

However, depreciation can have important consequences when the property is eventually sold.

What Happens to Depreciation When You Sell?

Depreciation reduces the property's adjusted tax basis over time.

When the property is sold, previously allowable depreciation may affect the taxable gain and can potentially result in depreciation recapture-related tax consequences.

This is why depreciation should be considered as part of a long-term real estate tax strategy rather than viewed only as an annual deduction.

Why Is Good Recordkeeping Important?

Real estate investors should maintain documentation related to:

• Original purchase price

• Closing costs

• Land allocation

• Capital improvements

• Appliances and equipment

• Depreciation schedules

• Property sale expenses

• Previous tax returns

These records can become particularly important years later when calculating the adjusted basis and potential gain on a property sale.

Plan Before Major Real Estate Decisions

Depreciation can affect taxes throughout the entire ownership period of a rental property.

Understanding the potential tax consequences before purchasing, renovating, converting, or selling a property can help investors make more informed decisions.

Tax planning can be especially valuable when multiple properties, significant improvements, or a potential property sale are involved.

Real Estate Tax Planning With James Ridout CPA

James Ridout CPA helps rental property owners and real estate investors understand depreciation and other tax considerations associated with their investments.

Our team can help review property basis, depreciation, rental income and expenses, improvements, and potential tax implications before major real estate transactions.

Whether you own one rental property or a growing portfolio, proactive planning can help you better understand the tax impact of your real estate investments.

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This article is intended for general informational purposes and should not be considered individualized accounting, tax, legal, investment, or financial advice. Real estate depreciation and tax treatment depend on the property and the taxpayer's individual circumstances.