Rental Property Depreciation: How to Depreciate Rental PropertyBusiness Taxes
Rental property depreciation can seem confusing at first because unlike depreciating one single asset — such as a car — rental property could theoretically be split up into several different assets, each with their own depreciation schedules.
But once you understand some general principles of both depreciation itself as well as how a rental property can be broken up, depreciating rental property really isn’t the monster challenge you may originally think it to be.
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What Is Depreciation?
Depreciation is the deduction taxpayers receive for the basis of capitalized assets they own.
Unlike the amount of money you pay for, say, advertising expenses in a given year — which you can deduct immediately — you cannot immediately deduct the cost of capitalized assets such as real estate.
Rather, you must take a portion of this cost annually via the depreciation deduction.
How to Depreciate Rental Property
Here’s exactly how to depreciate a rental property, step by step.
Note that this example is for a simple rental home that is rented out for profit at market rents.
For large commercial buildings, more advanced techniques such as cost segregation may be employed.
For properties with special tax treatment such as vacation homes and properties rented out for less than fair market value, other rules may apply.
1. Determine your basis in the property.
Your basis in a piece of property is generally the amount of money you paid for the property — financed or not — increased by the cost of other expenses you paid in order to acquire the property.
In a real estate context, these other expenses are generally settlement fees and closing costs paid by the buyer.
For a rental property, you typically determine your basis by looking at your settlement statement or HUD-1.
On the purchase of a rental home, your basis may, for example, consist of the following items:
- Contract sales price
- Personal property
- Commission paid from borrower’s funds at settlement
- Title services and lender’s title insurance
- Settlement or closing fee
- Owner’s title insurance
- Government recording charges
- Transfer taxes
- City/County tax/stamps
- State tax/stamps
Note that you cannot include costs you incurred to obtain your mortgage on the property in the property’s basis. These costs are generally indicated in the 800 section of the HUD-1. You may, however, amortize these costs and deduct them over the length of the mortgage on the property.
Amounts deposited into an escrow account — such as for insurance and property taxes — are not includible in your basis either since these amounts will be deducted when paid out.
Important: Amounts that you pay to enlarge or improve your rental property before you place it in service is also added to the property’s original cost basis.
2. Allocate your basis between land and building.
Now that you’ve calculated your total basis in your rental property, you must now allocate a portion of it to land and a portion of it to building.
This is because when you purchase a property, you are — in the eyes of the IRS — purchasing two separate assets: the building and the land it sits on.
And while you can depreciate the building portion of the asset, you cannot depreciate the land portion of the asset.
So you must make some reasonable allocation of your property’s total basis between land and building.
There are other ways to do it, but the most common way that tax preparers allocate a property’s basis between land and building is by using the county assessor’s records.
As part of their valuation of a property, county assessors provide two separate values for the property: the land value and the improvements value.
An easy way to allocate your basis between land and building is to determine the respective land and improvement percentages based on the assessor’s valuation and multiply those percentages by your total basis calculated in step 1.
Let’s say you bought the largest modern home in the United States, The One Bel Air in Los Angeles, for $190,000,000 and after basis adjustments on the HUD-1 your total basis in the property is $200,000,000.
You then go to the Los Angeles County Assessor Portal and input the address for The One Bel Air — 944 Airole Way, Los Angeles, CA 90077.
Upon doing so, you find the most recent parcel summary and note that the Los Angeles County Assessor has assigned to the property a land value of $32,491,171 and an improvements value of $88,913,881.
As percentages, the assessor determined that this property’s value is 26.76% land and 73.24% improvements.
You can then apply this 26.76% land percentage and 73.24% improvements percentage to your $200,000,000 total basis in the property to arrive at a $53,520,000 land basis and a $146,480,000 building basis.
3. Determine the date the property was placed in service.
You may think that you can only start depreciating a rental property on the day it is occupied by a tenant, but that would not be correct.
You can actually start depreciating rental property as soon as it is rent ready and you are actively marketing it for a lease.
4. Depreciate the building basis using the appropriate MACRS method.
Now that you’ve determined how much of your property that you can depreciation, namely, the building portion, you must calculate your depreciation deduction.
Under the most commonly used United States tax rules, residential rental property is depreciated over 27.5 years, and nonresidential real property is depreciated over 39 years.
However, you cannot simply take your basis in the building portion of your property and divide it by 27.5 years or 39 years and take that deduction every year.
Rather, rental property is depreciated using the mid-month convention, meaning that the property is assumed to be placed in service (or disposed of) in the midpoint of the month it was actually placed in service (or disposed of).
Rental Property Depreciation Example
Putting all these rules together, let’s walk through a rental property depreciation example.
Let’s you purchased a single-family home for $440,000 in December 2022, and after adjusting for various items on the HUD-1, you determine that your initial cost basis is $450,000.
You determine that a 60% / 40% split between building and land is appropriate, so your initial basis in the building is therefore $270,000 which is $450,000 x 60%.
Although you purchased the property in December 2022, you had to spend $30,000 in improvements on the building to make it livable, meaning that your total basis in the building is $300,000. The property was eventually rent ready in March 2023, at which point you listed it for rent.
The property was therefore placed in service in March 2023. So you would calculate the 2023 depreciation on building as follows:
$300,000 building basis
/ 27.5 years
/ 12 months in the year
x 9.5 months (half of March + April – December)
$8,636.36 depreciation deduction in 2023
Rental Property Depreciation FAQs
Here are our answers to some frequently asked questions about rental property depreciation.
When does rental property depreciation start?
Rental property depreciation starts when the property is ready and available to be rented out.
If you purchased the property occupied by a tenant, you would start depreciating the property on the day you purchased it.
If you purchased the property vacant, you would generally start depreciating it when the property is rent ready and you have started the process of finding a tenant to occupy it.
Logan is a practicing CPA and founder of Choice Tax Relief and Money Done Right. After spending nearly a decade in the corporate world helping big businesses save money, he launched his blog with the goal of helping everyday Americans earn, save, and invest more money. Learn more about Logan.