Rental Property Depreciation: How It Works, With a Worked Example

Rental property depreciation is the yearly tax deduction that lets you recover the cost of a rental building over time instead of deducting it all in the year you buy it. For many landlords it is one of the largest deductions on the return, and it costs nothing in cash that year. It is also the deduction most often figured wrong, usually because the land was not separated from the building, closing costs were left out, or an improvement was expensed or forgotten.

This guide covers the IRS rules that matter for a landlord with a few residential rentals, works through one property with numbers that add up, and lists the records your books should hold so your CPA can claim the deduction correctly year after year.

What rental property depreciation is and why it matters

A building wears out. The IRS lets you deduct that wear as depreciation, spread over a fixed recovery period. IRS Publication 527 explains that you begin depreciating a rental when you place it in service for the production of income, meaning when it is ready and available to rent. Land is different: Publication 527 says you can’t depreciate it because land generally doesn’t wear out, become obsolete, or get used up.

Depreciation matters for two reasons:

• It lowers your taxable rental income every year. On a typical single-family rental it can turn a positive cash flow into a small taxable loss on paper.
• It follows you to the sale. Depreciation reduces your basis, which increases your gain when you sell. And the reduction happens whether or not you claimed it: Publication 946 says you must reduce basis by the depreciation “allowed or allowable, whichever is greater.” Skipping the deduction gives you nothing in return.

The core rules: 27.5 years, straight line, mid-month

For residential rental property placed in service after 1986, the general depreciation system (GDS) under MACRS applies to most landlords. The key rules, from Publications 527 and 946:

The mid-month convention is why your first-year deduction is smaller than later years. A property placed in service in February gets 10.5 months of depreciation in year one, not 12 and not 11. Publication 527 shows this in its Table 2-2d, where February’s first-year rate is 3.182% and the rate for a full year is 3.636% (which is simply 1 divided by 27.5).

Figuring your basis and separating land from building

Your starting basis is generally what you paid for the property plus certain settlement and closing costs. Publication 527 lists costs that are added to basis, including abstract fees, legal fees, recording fees, surveys, transfer taxes, and title insurance. It also lists costs that are not added to basis, including fire insurance premiums and the costs of getting a loan, such as points, credit report fees, and lender-required appraisal fees. (Loan costs have their own treatment; your CPA will handle them separately.)

Then you split the basis between land and building. Publication 527 says the allocation is based on the ratio of each part’s fair market value to the value of the whole property at the time you buy it. If you are not sure of the fair market values, you can generally use the assessed values for real estate tax purposes. Many landlords use the assessor’s land-to-building split; others use an appraisal that breaks out land value. Which method fits your property is a judgment call to make with your CPA, and the method and the numbers should be documented in your files.

How to calculate depreciation on rental property: a worked example

Here is one property, start to finish. The numbers are illustrative.

The purchase. A landlord buys a single-family house for $300,000. At closing she pays $6,000 of costs that belong in basis (title insurance, recording fees, transfer taxes, and attorney fees), plus $3,000 in loan points and a $1,200 fire insurance premium, which do not.

Step 1: Basis. $300,000 + $6,000 = $306,000.

Step 2: Land vs building. The town assesses the property at $250,000: $50,000 land and $200,000 building. That is 20% land and 80% building.

Step 3: Placed in service. She closes in March, gets the house ready, and lists it for rent in April. April is the month it is placed in service, so year one gets 8.5 months (half of April plus May through December).

Step 4: The deduction.

Publication 527’s Table 2-2d builds the same mid-month math into rounded percentages: its own example of a house placed in service in February uses 3.182%, which is 10.5 ÷ 12 ÷ 27.5. For April the equivalent rate is 8.5 ÷ 12 ÷ 27.5, or about 2.576%, so a table-based figure can differ from ours by a dollar of rounding. The $61,200 allocated to land is never depreciated.

Step 5: What it does to basis. After year 1 and four full years (years 2 through 5), accumulated depreciation is $6,305.45 + (4 × $8,901.82) = $41,912.73. Her adjusted basis in the property, before any improvements, is $306,000 − $41,912.73 = $264,087.27. That lower basis is what gain is measured against if she sells.

Capital improvements depreciation vs repairs

Not everything you spend on a rental is deductible right away. Publication 527 says an expense is an improvement if it results in a betterment to the property, restores it (for example, replacing a substantial structural part), or adapts it to a new or different use. Improvements are capitalized and generally depreciated as if they were separate property, starting when they are placed in service. Repairs and maintenance that keep the property in ordinary working condition can generally be deducted in the year you pay them.

Continuing the example: in year 3 she replaces the roof for $18,000, finished in September. Publication 527 gives an improvement the same recovery period as the property it improves, so the roof starts its own 27.5-year schedule:

From then on, the house has two depreciation lines: the original building and the roof. Patching a leak the year before would typically have been a repair, deducted that year. The distinction gets fuzzy in real life, and the IRS has detailed rules on it, so ask your CPA about anything large or unusual.

Depreciation recapture when you sell (in brief)

When you sell, the depreciation you took (or could have taken) comes back into the picture through the lower basis. Landlords usually call this “depreciation recapture,” though the technical treatment for residential rentals is specific:

• Ordinary income recapture generally doesn’t apply. Publication 946 says there is no recapture for residential rental property unless it is qualified property for which you claimed a special depreciation allowance. Publication 544 explains that the section 1250 ordinary income rule reaches only “additional depreciation” above straight line, which a straight-line rental typically doesn’t have.
• But the gain from depreciation is taxed at its own rate. IRS Topic 409 says the portion of any unrecaptured section 1250 gain from selling real property is taxed at a maximum 25% rate.

Exchanges, installment sales, converting a rental to a home, and state taxes all change the picture. Before you list a property, have your CPA run the numbers using your depreciation history, which is why that history needs to be complete.

Bookkeeping for rental property: the depreciation records to keep

Your CPA prepares the return, but the return is only as good as the records behind it. Good bookkeeping for rental property keeps these on file for every property:

• The closing statement, with each cost marked as basis, loan cost, or expense
• The land and building allocation, with the source (assessment notice or appraisal) attached
• The placed-in-service date and evidence of it, such as the listing date
• A fixed asset schedule: one line per building and per improvement, with cost, date, recovery period, and depreciation to date
• Invoices and proof of payment for every improvement, kept separate from repairs in the books
• Prior-year depreciation figures as filed, so nothing is lost when you change preparers
• Any component disposed of or replaced (for example, the old roof), so your CPA can decide whether to remove its remaining basis (a partial disposition election)

Keep these for as long as you own the property and for years after you sell, because basis and depreciation determine your gain at sale. For how depreciation fits into the rest of a landlord’s books, see our guide to real estate accounting.

Who does what: your bookkeeper and your CPA

At JAV, we keep landlords’ books by property, track every improvement separately from repairs, and maintain the depreciation records above so tax season is a handoff, not a project. For tax preparation and planning, we work with trusted CPA partners, or with your own CPA, who uses those records to claim depreciation on your return and to plan for a sale. If your depreciation history is missing or you are not sure your basis was ever split correctly, that is a good first conversation to have with us.

This article is general information, not tax or legal advice. Talk with your CPA or attorney about your situation.