What it means
Depreciation is the accounting and tax idea that a building wears out over time, so its cost is spread over its useful life instead of being deducted at once. In the United States, the tax rules set fixed recovery periods for different kinds of property, and residential rental property has its own category.
To qualify, a building must be rented and at least 80% of its gross rental income must come from dwelling units, which are places where people live. A hotel or short-stay accommodation, where most guests stay for brief periods, is generally not treated as a dwelling unit.
Under the general system, the building portion of residential rental property is depreciated over 27.5 years in equal annual amounts. Commercial buildings are depreciated over a longer period, which makes residential rental property relatively attractive for investors.
The land is not depreciable, because it does not wear out. A buyer therefore has to split the purchase price between land and building, usually by using the property tax assessment ratio or an appraisal, and only the building amount is depreciated.
Details matter in the first and last years. The mid-month convention treats the property as placed in service in the middle of the month, so the first-year deduction is slightly less than a full year, and when the property is sold the depreciation taken reduces the tax basis, which can lead to depreciation recapture and additional tax on the gain.
Landlords should also be aware of other rules, such as those on passive activity losses, which can limit how much rental loss can be used against other income. Because tax rules change, owners should confirm the current recovery periods and limits with a tax adviser.
In practice
Real-world examples.
Example
An investor buys a four-unit apartment building for $800,000, with the land valued at $200,000. She depreciates the $600,000 building over 27.5 years, giving a yearly deduction of about $21,818.
Example
A family converts a large home into three rented flats and finds that all of the rent comes from dwelling units. The accountant treats the building as residential rental property, and the owners claim depreciation on the building cost and the improvements. They keep the invoices for the conversion work, because each improvement is tracked and depreciated separately.
Example
A landlord owns a building with ground-floor shops and upstairs flats, and only 55% of the gross rent comes from the flats. Because the 80% test is not met, the building is not treated as residential rental property and the longer commercial recovery period applies. The landlord's accountant recommends tracking the income split every year, because a change in the mix of tenants could alter the classification.
Formula
Calculation
Annual depreciation = depreciable building cost / 27.5 years.
Suppose an investor buys a small apartment block for $700,000, of which the land is valued at $150,000. The depreciable building cost = 700,000 - 150,000 = $550,000. Annual depreciation = 550,000 / 27.5 = $20,000 for a full year. If the landlord collects $60,000 of rent and pays $25,000 of cash expenses, taxable rental profit before other items = 60,000 - 25,000 - 20,000 = $15,000.Case study
Seen in the real world.
Willowbrook Homes is an illustrative, fictional small property company that bought a 12-unit apartment building for $1,800,000. The bookkeeper depreciated the entire purchase price over 27.5 years, including the value of the land.
At year end, the accountant noticed that the land was valued at $300,000 on the property tax assessment, about one sixth of the price, and that land cannot be depreciated. The correct depreciable amount was therefore $1,500,000, giving a yearly deduction of about $54,545 instead of the $65,455 claimed.
Willowbrook amended its return and adjusted its fixed asset register. The illustrative lesson is that the first step in depreciating a rental building is to separate land from building, and to confirm that the 80% test is passed. The company now keeps a short checklist for each acquisition, covering the allocation of the price, the placed-in-service date and the income mix.
Watch out
Common mistakes.
- Depreciating the land along with the building, when land is not a depreciable asset.
- Assuming every rented property qualifies, when short-stay accommodation and mixed-use buildings may not meet the 80% test.
- Forgetting that depreciation reduces the tax basis, which increases the taxable gain when the property is sold.
Questions
People also ask.
How long is residential rental property depreciated?
Under the general US system it is depreciated on a straight-line basis over 27.5 years, though the rules should be confirmed for each tax year.
What counts as a dwelling unit?
A place with basic living accommodation such as sleeping, cooking and toilet facilities, and hotels or similar short-term lodging are generally excluded.
Can improvements be depreciated too?
Yes, capital improvements are depreciated over their own recovery periods, while repairs are usually deducted in the year they are paid.
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