Depreciation in Real Estate Explained
Disclaimer: This article is for educational purposes only and does not constitute legal, tax, or financial advice. Tax laws change frequently and vary by jurisdiction. Consult a qualified CPA, tax attorney, or financial advisor before making investment decisions based on tax considerations.
Depreciation is one of the most powerful tax advantages in real estate investing. It allows you to deduct a portion of a property's value from your taxable income each year, even though the property may actually be increasing in value. This "phantom expense" reduces your tax bill without requiring any cash expenditure, effectively increasing your after-tax returns.
How depreciation works
The IRS considers buildings (not land) to be wasting assets that lose value over time due to wear and tear. For residential rental property, the IRS allows you to deduct the building's value over 27.5 years. For commercial property, the period is 39 years.
Annual Depreciation = (Property Value − Land Value) ÷ 27.5
Example: $250,000 property, 75% building / 25% land
Building value: $187,500
Annual depreciation: $187,500 ÷ 27.5 = $6,818/year
At a 24% tax bracket, $6,818 in depreciation saves $1,636 in taxes annually. You did not spend $6,818 — it is a paper deduction. Your actual cash returns increase by the tax savings.
Depreciation recapture
When you sell a depreciated property, the IRS "recaptures" the depreciation you claimed. Recaptured depreciation is taxed at 25% (not your ordinary income rate). If you claimed $68,180 in depreciation over 10 years and sell the property, you owe 25% of $68,180 = $17,045 in depreciation recapture tax.
You can avoid recapture by doing a 1031 exchange into a new property, deferring all taxes. If you hold until death, heirs receive a stepped-up basis, permanently eliminating recapture.
Cost segregation: accelerated depreciation
A cost segregation study reclassifies building components into shorter depreciation schedules (5, 7, or 15 years instead of 27.5). Items like appliances (5 years), carpeting (5 years), land improvements (15 years), and certain fixtures can be depreciated much faster, creating large deductions in the early years of ownership.
Bonus depreciation
Under current tax law, 100% bonus depreciation allowed investors to deduct the entire cost of qualifying short-lived assets (identified through cost segregation) in the first year. This is phasing down: 80% in 2023, 60% in 2024, 40% in 2025, 20% in 2026. Even at reduced rates, the first-year tax benefit is substantial.
Related articles
- Real Estate Tax Benefits
- Cost Segregation Guide
- 1031 Exchange Guide
- Real Estate ROI Guide
- Rental Property Analysis