What Landlords Need to Know About Depreciation and Property Value

Key Takeaways

• Depreciation is a useful financial tool that landlords should know how to leverage.
• Depreciation can be complicated for landlords and investors to accomplish alone.
• Partnering with a property management company can lessen the workload of managing your rental property’s finances.

Owning a rental property brings many financial benefits, and one of the most valuable tools at a property owner's disposal is depreciation. While many property investors focus on rental income and property appreciation, understanding how depreciation works can make a huge difference in tax savings over the years.

In this guide, you will learn what rental property depreciation is, how it works, how to calculate it, and how it can impact your bottom line. Plus, we will share actionable tips to help you make the most of your investment.

If you are looking for expert guidance in managing your rental properties, make Evolve Real Estate and Property Management your go-to partner. We help property owners maximize returns while taking the guesswork out of property management and compliance.

What Is Depreciation in Rental Property?

Depreciation is an accounting method that allows property owners to spread out the cost of their rental property and improvements over a period of years. This process provides a valuable tax deduction each year that can significantly reduce taxable rental income.

The IRS defines the recovery period as 27.5 years for residential properties and 39 years for commercial ones. During this period, you can deduct a portion of your property's value from your taxable income annually.

Why does this happen? Over time, buildings naturally lose value due to wear and tear, aging, or obsolescence. The IRS allows you to account for this loss on your tax return, even if the property's market value is increasing. As long as you own the property and use it to generate rental income, you can claim depreciation.

Depreciation offers an opportunity to spread out deductions instead of taking them all in one year, which helps you manage your tax liability in a more predictable and sustainable way.

How to Depreciate a Rental Property

Depreciation begins once your property is ready and available for rent. If you put the property on the rental market midway through the year, the deduction is prorated for that first year.

For subsequent years, under IRS guidelines, you can claim depreciation at a rate of 3.636% annually for residential properties. It is important to remember that depreciation applies only to the building, not the land it sits on.
The IRS uses the Modified Accelerated Cost Recovery System (MACRS) to calculate depreciation. Under MACRS, there are two options:

1. General Depreciation System (GDS)

This is the system most rental property owners use. Under GDS, residential property depreciated over 27.5 years.

2. Alternative Depreciation System (ADS)

ADS applies if:

• The property is used less than 50% for business
• It is used for farming
• It is financed with tax-exempt bonds
• It is used for tax-exempt activities

With ADS, the recovery period is either 30 or 40 years, depending on when the property started generating monthly rent.

How to Calculate Rental Property Depreciation

The calculation process is simple once you know your property’s cost basis. Follow these steps:

Step 1: Determine the Cost Basis

Your cost basis is:

Purchase Price + Closing Costs + Improvements - Land Value

For example, if you paid $1,000,000 for a property, paid $20,000 in closing costs, added a $4,000 deck, and the land is worth $60,000, your cost basis would be:
$1,000,000 + $20,000 + $4,000 - $60,000 = $964,000

Costs to include:

• Legal fees
• Recording fees
• Transfer taxes
• Title insurance
• Surveys
• Utility installation fees
• Any payments made to cover seller obligations (back taxes, repairs)

Costs to exclude:

• Fire insurance
• Pre-closing rent
• Loan-related fees (mortgage insurance, origination fees, points)

Step 2: Calculate the Annual Depreciation Deduction

Use the straight-line method:
Annual Depreciation = Cost Basis ÷ 27.5 years

Or, simply multiply the cost basis by 3.636% each year.

Example:
If your adjusted cost basis is $964,000:

$964,000 x 3.636% = $35,072 annual deduction.

For the first year, use the prorated percentage based on the month the property entered service.

Depreciation Recapture Tax: What You Need to Know

Depreciation is a fantastic tool while you own the property, but it comes with a caveat when you sell. The IRS will apply a depreciation recapture tax to the gains from your sale.
This tax is based on the amount of depreciation you claimed during ownership. The recapture rate is capped at 25%. After applying recapture tax, any remaining profit is subject to regular capital gains tax.

How to Avoid Depreciation Recapture Tax

One common strategy is to use a 1031 Exchange, which allows you to defer both depreciation recapture tax and capital gains tax if you reinvest the proceeds from your property sale into another similar property.

To qualify, you must:

• Identify up to three replacement properties within 45 days of the sale
• Complete the purchase of a replacement property within 180 days

By doing this, you continue building your rental portfolio while deferring taxes to a later date.

Additional Tips for Smart Depreciation

• Keep detailed records of all improvements and expenses
• Consult a tax professional to optimize deductions
• Plan your exit strategy ahead of time to manage recapture tax exposure
• Stay current on tax law changes, especially regarding 1031 Exchanges and depreciation rates

When you are depreciating your rental property's value, there are several important points to keep in mind to make sure you are doing it correctly and making the most of the tax benefits. Here is a clear list for you:

Conclusion

Understanding how depreciation affects your rental property’s value is key to making smart financial decisions as a landlord. It can lower your tax bill and boost your long-term returns, but it also comes with a few important rules to follow. Staying on top of these details takes time and expertise.

That is why many landlords choose to work with a professional property management company. If you want to simplify the process and get the most out of your investment, Evolve Real Estate and Property Management is here to help. Let their experienced team handle the details so you can focus on growing your portfolio.