The Depreciation Tax Allowance Calculation for Rental Property

Rental property depreciation (also known as cost recovery) is one of the biggest tax deduction benefits real estate investors enjoy by owning rental properties.

The beauty of the rental property depreciation allowance lies in the fact that it is simply a “paper loss” the real estate investor can write off during each year the rental property is owned without having to shell a dime from out of pocket.

The investor can legally deduct an amount for depreciation as cost recovery each year from the cash flow he or she collected from the asset during the past twelve months of ownership and therein lower his or her tax liability for that past year.

But unlike say, mortgage interest (which is also a legal tax deduction), real estate investors never have to fork out any money for depreciation on rental property.

In this article, we will discuss rental property depreciation – its concept, limits, application, and formula.

Depreciation

The concept behind a tax depreciation deduction is based upon a principal known as “useful life”.

The idea is straightforward. That no matter how grand and prestigious a building may be when it’s constructed, any physical structure does have a physical life and will eventually wear out, deteriorate, or become obsolescent.

In other words, brick and mortar is finite and realistically can only last for so many years.

Furthermore (as a result of this deterioration), the owner therefore is suffering a financial loss by owning the property (because it is deteriorating) and as such should be granted the benefit to “recover the cost” from his or her income taxes as a result of the property’s diminishing useful life.

This is the purpose for IRS form 4562. So an owner of rental income property can claim a tax depreciation deduction on any rental properties that he or she has owned for the past twelve months.

Fair enough. So let’s consider some of the limitations the IRS has in place for real estate investors who attempt to get this tax deduction for the rental income properties they own.

Limitations

In order for a taxpayer to be allowed to take a rental property depreciation deduction, the property must at least meet the following requirements:

• A taxpayer must use the property in business or in an income-producing activity (a personal residence doesn’t count).
• The property must have a determinable useful life of more than one year.
• The property cannot be placed in service and disposed of in same year.

Likewise, the tax deduction for depreciation only applies to the physical structures (called “improvements”) of the property, not to the land. There is no cost recovery allowance for the value of the land.

What’s more, the depreciation begins when a taxpayer places property in service for use for the production of income (i.e., takes title) and ceases to be depreciable when the taxpayer has fully recovered the property’s cost or other basis or when the taxpayer retires it from service (i.e., transfers title); whichever happens first.

In other words, you will not get a tax depreciation deduction for your income property past its “useful life”, nor after you sell it.

About Useful Life

Useful life is a term used by the IRS to specify the number of useful years it attributes to rental property in order to arrive at the depreciation deduction allowable. The useful life is strictly used for tax purposes only, however, and does not necessarily imply the actual physical life expectancy of the physical asset.

In this case, the tax code currently regards the useful life for residential property as 27.5 years and for nonresidential property as 39 years.

For instance, a building that derives all or nearly all (80% or more) of its income from dwelling units such as single-family homes, multifamily, apartment buildings, condos and so forth is residential and thus can be depreciated 27.5 years. Property that derives its income from non-residential sources such as offices, retail space and industrial tenants is nonresidential and thus depreciated 39 years.

Okay, let’s move on and show you how to compute annual depreciation allowance.

How to Compute

For our purposes, we will refer to an annual depreciation allowance and ignore what the tax code calls the “mid-month convention.”

This convention applies to the year the asset is placed into service and whatever year it is disposed and states that you are allowed to take only one-half of the depreciation normally allowed for whatever month the property is purchased and then subsequently sold.

So we are dealing only with the depreciation tax allowance taken annually during the holding period in between purchase and sale.

First, determine the depreciable basis.

This is essentially the original value of the rental property improvements (remember, you cannot depreciate land).  Secondly, divide that depreciable basis by what the current tax code attributes to the rental property’s useful life.

Depreciation Allowance (annual) = Depreciable Basis / Useful Life

Example

Say you purchased a duplex thirteen months ago for $500,000 of which you attribute $400,000 to the building and $100,000 to the land. What is your annual depreciation allowance?

In this case the depreciable basis is $400,000, the useful life is 27.5 years because this is residential property, and since it is not in either the year of purchase or sale the mid-month convention is not applicable.

Depreciation Allowance (annual) = Depreciable Basis / Useful Life
Depreciation Allowance (annual) = 400,000 / 27.5 = 14,545

Illustration (click image to enlarge)

Conclusion

There is much more to rental property depreciation then we have discussed here such as capitalized costs of acquisition and additions or capital improvements to the property. But hopefully you have gotten the idea.

Naturally, we strongly recommend that you always consult a qualified tax person before making any real estate investment decisions.