Rental properties are popular investments for good reason. A savvy investor can enjoy steady cash flows and build equity while the property appreciates over time.
There are also tax advantages. The IRS lets you deduct legitimate expenses related to your rental property, including:
- mortgage insurance,
- property taxes,
- operating expenses,
- maintenance, and
You take these deductions during the same year you spend the money and report them along with any rental income on your Schedule E tax form.
You can also deduct the cost of buying and improving your rental property, but it works differently. Instead of claiming one huge deduction when you buy the property, you depreciate the costs across the useful life of the property.
If you sell the investment, the IRS is going to want some of that depreciation deduction back. This is known as depreciation recapture. Here’s what you need to know about rental property depreciation and depreciation recapture.
What rental property can I depreciate?
The IRS says you can depreciate a rental property if all these statements are true:
- You own the property. As far as the IRS is concerned, you own it even if you’re servicing debt on the property.
- You use the property in your business or income-producing activity (i.e., this is a business or rental property).
- The property has a determinable useful life. That means it must be something that wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes. Rental properties pass this test.
- The property is expected to last at least one year.
You can’t depreciate a rental property that you put in service and sell (or otherwise take out of service) within the same year. And, since land doesn’t generally wear out, get used up, or become obsolete, you can’t consider it depreciable property. Nor can you depreciate the costs of clearing, planting, and landscaping, since the IRS considers those part of the cost of the land.
Since you depreciate the cost of the building—and not the land—you have to allocate the costs. An easy way to figure out the individual costs is to look at your property tax bill and calculate the ratio between the value of the land and the value of the building. Here’s an example. Assume you buy a rental house for $240,000 and the property tax statement shows this:
Some quick math shows that the value of the land is 25% of the total value of the property. This is true even if you paid a different amount for the property (property tax valuation doesn’t usually line up with market value).
To figure out the value of the land based on the amount you paid, multiply the purchase price by 25%. In this example, that’s $240,000 multiplied by 25%, or $60,000. Your cost basis is the remaining $180,000. That's what you can depreciate over time.
When can I start depreciating rental property?
Say you buy the rental property on Jan. 1 and spend the next several months getting it ready for tenants. On April 1, the house is good to go, so you start advertising. You find a tenant and the lease starts June 1. With three different dates -- Jan. 1, April 1, and June 1 -- when do you start depreciating?
The IRS says you can start depreciating rental property as soon as it’s placed in service -- that is, when it’s ready and available to use as a rental. In this example, the house was ready to rent April 1, so even though the tenant didn’t move in until June 1, you can start depreciation for tax purposes on April 1.
How much can I depreciate each year?
Residential rental property placed into service after 1986 is depreciated using the Modified Accelerated Cost Recovery System (MACRS), an accounting system that spreads depreciation deductions over the "useful" life of the property. Residential rental property has a useful life of 27.5 years.
This means you depreciate 3.636% of the cost basis each year. The cost basis is the amount you paid to buy the property (whether you paid cash or financed it), including sale of the property, transfer, and title fees.
Some costs can’t be included in the cost basis, including:
- fire insurance premiums,
- any rent paid before closing, and
- the costs of getting or refinancing a loan, including appraisal fees, credit reports, mortgage insurance premiums (MIPs), and points.
Your cost basis also includes the cost of any improvements you make beyond buying the property. The improvements must be a "material part of" and add "real" value to the property.
To add "real" value, the improvement must give an appraiser good reason to bump up the value of the property. A new deck or a substantial kitchen remodel qualify for this.
Two MACRS options
It’s worth noting there are two MACRS options: The General Depreciation System (GDS) and the Alternative Depreciation System (ADS).
GDS applies to most rental properties placed. You’ll use it unless you make an irrevocable election for ADS or you’re required by law to use ADS. You must use ADS if the property:
- is used for business 50% of the time or less,
- has a tax-exempt use,
- is financed by tax-exempt bonds, or
- is used primarily for farming.
If you are required to use ADS, you depreciate the property over 30 years if it was placed in service after Dec. 31, 2017. If it was placed in service earlier, you depreciate over 40 years.
How do I depreciate partial years of rental property?
If your rental property is in service for only part of the year, you don’t depreciate the entire 3.636% for that year. Instead, the IRS tells you exactly how much you can depreciate based on the month you put the rental property into service:
In our example, you put the home into service during April, so you depreciate 2.576% of your cost basis for the first year. Remember, the cost basis uses the value of the building and not the land. That's $180,000 in the example.
The cost basis also includes closing costs and any improvements you make beyond buying the property. If you paid $10,000 in closing costs and $20,000 for improvements, for example, your total cost basis would be $210,000.
Therefore, you can depreciate $5,409.60 the first year the property is in service ($210,000 x 2.576%), and then $7,635.60 each year thereafter ($210,000 x 3.636%).
You continue to depreciate for up to 27.5 years or until you retire the property from service, whichever comes first. The property is considered retired from service when:
- you no longer use it as an income-producing property,
- you sell or exchange it,
- you convert it to personal use,
- you abandon it, or
- the property is destroyed.
How does depreciation recapture work on rental property?
At some point, you may want to sell your rental property. Depreciation will play a role in the amount of taxes you’ll owe when you sell. Because depreciation expenses lower your cost basis in the property, they ultimately determine your gain or loss when you sell.
If you hold the property for at least a year and sell it for a profit, you’ll pay long-term capital gains taxes. Depending on your income level, the tax rate is 0%, 15%, or 20% for 2019. If you’re a higher-income taxpayer, you may also be on the hook for a 3.8% net investment income tax.
Of course, the IRS remembers all those depreciation deductions and they’ll want some of that money back. That's what depreciation recapture does. This is based on your ordinary income tax rate and is capped at 25%. It applies to the portion of the gain attributable to the depreciation deductions you’ve already taken. You report depreciation recapture on IRS Form 4797, Sales of Business Property.
Here’s an example. Say you hold the rental property you bought for $240,000 for 10 years and you’ve written off $74,130 in depreciation deductions. That's $5,409.60 for the first year, since it was placed in service in April, and $7,635.60 each year for the remaining nine years.
In this example, your adjusted cost basis in the property after 10 years is $135,870 (the original cost basis of $210,000 less the $74,130 depreciation). If you sell for, say, $300,000, you’ll recognize a gain of $164,130 ($300,000 minus $135,870).
While it would be nice to pay taxes at the lower capital gains rate on the entire gain, you’ll pay up to 25% (based on your ordinary tax rate) on the part that’s tied to depreciation deductions. If you owe the maximum, it would be 25% of $74,130, or $18,532.50.
The remaining $90,000 is taxed at your regular long-term capital gains tax rate. Assuming you’re in the top bracket, that would be $18,000 in capital gains taxes. All in all, you’re looking at $36,532.50 in taxes.
Depreciation recapture applies to the lesser of the gain or your depreciation deductions. If you sell the property for $200,000, for example, you’ll have a gain of $64,130. Since that’s less than the $74,130 depreciation deductions you’ve taken, the recapture rate of 25% applies to the entire $64,130 gain for a total tax bill of $16,032.50.
Depreciation recapture when selling a rental property for a loss
Depreciation recapture doesn’t apply if you sell for a loss. Assume the real estate market is tanking and you sell for $100,000. In this case, no depreciation recapture is required; instead, you would report a loss of $35,870.
While this looks like a big loss, remember that you’ve already benefited from $74,130 in depreciation deductions over the previous 10 years. So your investment comes out with a gain of just over $38,000.
Provided you owned the property for more than a year, the loss is considered a Section 1231 loss, which means it can be used to reduce your tax liability during the tax year. You can also carry back the loss to offset the previous two years of taxable income, though you’ll have to refile those tax returns. Or you can carry it forward to offset future income for up to 20 years.
Find a good tax professional
Keep in mind that these examples are overly simplified. Also, rental property tax laws are complicated and change periodically. Unless you're a real estate tax law rock star, you should work with someone who is. Find a qualified tax accountant when you establish, operate, and sell a rental property. That way you’ll receive the most favorable tax treatment possible and avoid any surprises at tax time.