Property Management Blog

Key Takeaways

1. Depreciation Reduces Taxable Income
   Landlords can deduct a portion of a property's value each year (excluding land) over 27.5 years for residential rentals, reducing their annual tax liability and increasing profitability.

2. Only the Building Depreciates
   The value of the land is not depreciable—only the structure is. Accurate property valuation is crucial to calculate eligible deductions correctly.

3. Watch Out for Depreciation Recapture
   When selling a property, any depreciation previously claimed may be subject to a separate tax (up to 25%), known as depreciation recapture.

4. 1031 Exchange Can Defer Taxes
   Using a 1031 Exchange allows landlords to defer both capital gains and depreciation recapture taxes by reinvesting in another like-kind property within a specified timeline.

As a property owner, understanding how depreciation impacts your rental investment is essential to maximizing returns. While all properties naturally lose value over time, the IRS allows you to turn that gradual decline into a tax advantage. 

By using depreciation strategically, landlords can offset taxable income, reduce annual tax liabilities, and enhance long-term profitability.

This guide by SGI Property Management Dallas will walk you through the fundamentals of depreciation, how it affects property value, and how you can use it to strengthen your rental business.

What Is Depreciation in Real Estate?

Depreciation refers to the gradual decrease in a property’s value due to wear and tear, age, or external factors like market shifts. The IRS recognizes that buildings, unlike land, have a limited useful life. 

To account for this decline, they allow landlords to deduct a portion of the property's value annually over a specific period. This tax break helps cover the cost of maintaining and operating the rental property.

In addition to physical deterioration, economic conditions such as downturns in the housing market can also contribute to a property's devaluation over time, referred to as economic depreciation.

How Rental Property Depreciation Works

When you purchase a rental property, you’re making a significant capital investment. To ease the financial burden, the IRS permits you to recover the cost of the building (excluding land) over time through annual depreciation deductions.

For residential rental properties, the IRS assigns a depreciation period of 27.5 years. This means you can deduct a portion of the property’s value each year across nearly three decades. If the property is used for business or farming, longer recovery periods may apply depending on usage.

Understanding the Depreciation Recovery Period

The recovery period is the length of time over which you’re allowed to deduct depreciation. For real estate, this period is longer than most other assets. For example, while business equipment or furniture depreciates over 5 to 7 years, residential properties have a 27.5-year schedule. Commercial real estate depreciates over an even longer timeframe—39 years.

How to Calculate Annual Depreciation

Calculating depreciation is relatively straightforward. First, subtract the land value from the total purchase price since land doesn’t depreciate. Then, divide the remaining amount, the cost of the building, by 27.5 years to determine your annual deduction.

For instance, if the building’s value is $275,000 (excluding $75,000 for the land), you’d divide $275,000 by 27.5. That gives you a yearly depreciation deduction of $10,000.

This deduction can be applied annually until you’ve fully depreciated the property or decide to sell.

Tax Advantages of Depreciation

Investing in rental property comes with several tax benefits. Expenses such as mortgage interest, insurance, property taxes, repairs, travel, and professional services are typically deductible in the year they’re incurred. 

However, depreciation stands out because it allows you to write off a portion of the property’s cost incrementally over time.

This annual deduction can significantly reduce your taxable rental income, helping you keep more of your earnings. Unlike immediate expenses, depreciation works as a long-term tool to manage and mitigate tax obligations, especially for landlords with multiple properties.

Beware of Depreciation Recapture Tax

While depreciation offers short-term savings, it’s important to consider its long-term implications, specifically, depreciation recapture tax. When you sell your rental property, the IRS may require you to pay tax on the amount of depreciation you previously claimed.

This recapture is taxed separately from capital gains and is generally capped at 25% of the total depreciation claimed. The tax is calculated on the difference between your adjusted cost basis (original cost minus depreciation) and the sale price.

However, you can potentially defer this tax through a 1031 Exchange.

Using a 1031 Exchange to Defer Taxes

A 1031 Exchange, named after Section 1031 of the Internal Revenue Code, allows landlords to defer both capital gains and depreciation recapture taxes. To qualify, you must reinvest the proceeds from the sale of one investment property into another "like-kind" property within a specific timeframe.

The process requires you to identify up to three replacement properties within 45 days and complete the purchase within 180 days. 

If done correctly, this strategy lets you defer tax liabilities while continuing to grow your real estate portfolio. Keep in mind that the new property must also generate rental income or serve a business purpose.

Key Factors That Affect Depreciation Deductions

Accurate Property Valuation

You must separate the value of the land from the structure since only the building qualifies for depreciation.

Professional Guidance

Tax rules around depreciation can be complex. It’s wise to consult with an accountant to ensure accurate calculations and compliance with IRS regulations.

Eligibility Requirements

Not all properties qualify. You must own the property, use it to produce income, and expect it to last longer than a year.

Who Can Claim Rental Property Depreciation?

To qualify for depreciation deductions, landlords must meet the following conditions:

• Ownership: You must own the property, either outright or with financing.

• Income-producing use: The property must be used in a business or rental capacity.

• Determinable useful life: The asset must have a limited life span, typically over one year.

• Ongoing use: The property must be expected to generate value over time.

Bottom Line

Depreciation is a key tax advantage for landlords, reducing taxable income and increasing yearly savings. 

But it’s crucial to understand long-term impacts like depreciation recapture when selling. With smart planning, such as using a 1031 Exchange, you can benefit from depreciation while avoiding costly tax surprises.

Taking a proactive approach now ensures your real estate investments remain profitable well into the future.

Contact SGI Property Management Dallas today!