In order to understand federal taxes for real estate, you have to understand depreciation. Most of the tax advantages and tax strategies for real estate all have to do with ways to take advantage of the tax savings that come from depreciation. The good news is you don’t have to understand all the nitty-gritty details in order to make use of these tax strategies as long as you understand the basic concept of how it works.

What is Depreciation

Depreciation only applies to assets that you buy for business use, and property rental is considered a business use of the asset. So if the property is just your home, and you don’t rent it out, then depreciation doesn’t apply.

When you buy an expensive item for a business, you can’t usually just subtract the whole cost of an item as an expense from your taxable income the year you buy it. The tax code generally requires that large business purchases be depreciated. Depreciation just means that you get to subtract a fraction of the cost of the item each year, over a number of years.

For a residential rental property, the building is generally depreciated over 27.5 years. So for example, you might buy a house for $200,000, with the value of the land appraised as $50,000 and the value of the house structure appraised for $150,000. In that case, you can deduct from your rental expenses is $150,000 / 27.5 = $5455 each year for up to 27.5 years.

Depreciation isn’t optional. Even if you didn’t subtract depreciation from your income tax calculations each year, you still have to pay back the depreciation recapture when you sell the property as if you took it, even if you never actually took the depreciation. So you definitely want to claim the depreciation that you are entitled to claim.

Calculating the Improvement Value for Depreciation

Land never gets depreciated, just the “improvements,” which means the value of the building and any other stuff that was built on the land.

There are a few ways you can determine the improvement value for a property. If an appraisal was done, such as when you bought it, an appraisal is the best source of that information. Otherwise, the second-best option is your county tax appraisal if it has information that shows their estimated value for your property’s improvement value along with the land value. Either of those sources of information are considered acceptable to find the ratio of the improvement to land values. You can not use an arbitrary ratio, or a “rule of thumb” like 80% or 90% as many CPAs do because they don’t know that isn’t allowed.

If your actual cost is different from the appraised amount, you’ll need to calculate the value of the cost of the improvements by multiplying your actual cost by the proportion of the values from the appraisal, like this:

Improvement Value = Actual  Total Cost * { Improvement Appraisal \over  Total Appraisal }

That will calculate the improvement value as a portion of your actual cost. You should then also add any relevant acquisition costs that can be included in depreciation, such as title recording fees, lawyer fees, etc. It’s a good idea to use a tax professional with real estate expertise when calculating the depreciation basis because it’s difficult to fix it later if you don’t do it correctly.

27.5 Year vs. 39 Year Property

Buildings that are residential use are depreciated on a 27.5 year schedule, and buildings that are nonresidential are depreciated on a 39 year schedule.

Rentals with an average stay of less than 30 days are classified as nonresidential, and so they have to be depreciated over 39 years. This is one of the most common mistakes that tax preparers make. They don’t realize that they have to change their depreciation period when they have a short-term rental. See our article on the STR Loophole for more specifics about calculating the average stay.

Your depreciation period can change from year to year if the average stay of your tenants is above or below 30 days from year to year. Your accumulated depreciation from previous years remains the same as it is, but you simply change the depreciation calculation to take a different portion in the current year based on the current year’s depreciation type.

What if there are multiple units on the property?

If you have separate buildings (actual separate physical structures), and one is used as a long term rental and the other is a short term rental, then you can have one building that is depreciated 27.5 years and the other can be 39 years.

If you have multiple units in the same building (such as a typical duplex), then you have to calculate whether 80% of the rental income for the building comes from residential (not short-term) use. The calculation isn’t based on square footage, but by the amount of rental income. So if 80% or more of the rental income is from residential use, then the whole building is depreciated as a 27.5 year residential building. Otherwise it’s a 39 year nonresidential building. If one of the units is owner-occupied, then you make the calculation using what would be the fair market rent for your unit. This is based on section tax code section 168(e)(2)(A).

Mortgage Fees and Points

If you paid mortgage fees when acquiring the property (or when doing a refinance), those costs are also spread out as deductible expenses over time. This includes costs like loan origination fees and mortgage points. These lender fees are “amortized” over a period of time equal to the term of the loan (30 years, 15 years, etc.). That just means the you get to deduct a fraction of the fees each year. It’s very similar to depreciation, but one difference is that there is no recapture (see below). And if you sell the property, you can deduct any remaining mortgage fees that weren’t yet fully amortized.

Placed in Service Date

Depreciation starts from the date the rental property is “placed in service.” That is the date that it is first made available for rent, such as when you post an ad on Zillow or Facebook and start accepting applications from any prospective tenants. If you buy a property that already has tenants when you buy it, then the placed in service date is the date you bought it.

Depreciation Recapture

If you later sell a property, the depreciation usually gets “recaptured”. What this means is that the depreciation you took during the time it was a rental property now gets taxed if you sell the property for a profit.

If you sell the property at a loss and the property is worth less than the price you paid for it minus the depreciation you took, then there is no recapture. But with real estate, most often the value has gone up, and so there is depreciation to recapture. The tax rate you pay on the recapture of real estate depreciation is generally your ordinary tax rate, but capped at a maximum of 25%.

So consider an example where you bought a house for $200,000, rented it for some years and benefited from a total of $40,000 of depreciation during those years, and then you sell it for $300,000. You made a profit of $300,000 – $200,000 = $100,000. But for tax purposes, there is also the $40,000 of recaptured depreciation, which is taxed at up to 25%. The other $100,000 of profit is taxed at the long term capital gains rate (which is a lower tax rate).

One other wrinkle, if some portion of the property was classified as personal property rather than real property, that portion of the gains is taxed at your ordinary income tax rate, without the benefit of the 25% cap. That may be the case if you did a cost segregation study, or if you otherwise classified some portion of the property as personal property that is separate from the real property.

The Technical Details

If you just want to know the basics of how depreciation and recapture affects your taxes, you don’t need to read this section. But if you want to learn about more of the nitty-gritty details, read on.

An asset with a useful life of more than a year that is used for a business is “section 1231 property”, which means it falls under section 1231 of the tax code, and it’s depreciable. Under that umbrella there is “section 1250 property,” which is real estate, and “1245 property” which is everything else.

The MACRS system defines the depreciation period of various classes of assets (5 years for cars and cattle, 7 years for office furniture, 27.5 years for residential real estate, 39 years for commercial real estate, etc.). Assets can be depreciated using straight-line depreciation by just dividing the value over the number of years, and taking that much each year. Some asset classes can also use accelerated depreciation, including the double-declining balance (DDB) depreciation method that instead takes more depreciation in the early years, and less in later years. Real estate used to qualify to use accelerated depreciation, but since MACRS was introduced in 1986, real estate can only use straight-line depreciation.

The basis of property is used to determine how much you have in capital gains when you sell it. The basis is reduced by the amount of depreciation you have taken, and increased by any improvements you have made to the property, and that gives you the adjusted basis. If you sell the property for less than the adjusted basis, then there is no recapture of depreciation and no capital gains, and so no taxes are due.

But if you sell for more than the adjusted basis, then the depreciation is “recaptured”, which means you are essentially repaying for the tax savings from depreciation that you previously got to claim. The tax rate on recapture depends on the type of asset and the type of depreciation that was used. Section 1250 property (real estate) that used accelerated depreciation would be subject to recapture at your ordinary income tax rates. But section 1250 property hasn’t qualified to use accelerated depreciation since 1986, so that’s only an issue for property that was bought before that time. For most real estate, all the depreciation will be straight-line depreciation, and the recapture of that depreciation is called “unrecaptured section 1250 gain.” That type of recapture is taxed at your ordinary tax rate, but capped at a maximum of 25%.

Section 1245 recapture (recapture of depreciation on property that isn’t classified as real estate) is taxed at your ordinary income tax rate.

If you have additional capital gains above the recapture of depreciation, the rest of it will be taxed at the long-term capital gains tax rates.