What Is Rental Property Depreciation? 7 Things to Know

Rental property depreciation is the process of spreading the costs of purchasing and improving an investment property over the course of its useful life. Residential real estate's useful life is 27.5 years, and for commercial real estate, it's 39 years.

Certain conditions must be met before an investor can claim depreciation on a piece of rental real estate.

• The investor must own the property.
• The investor must use the property for income-producing activity.
• The property must have a determinable useful life.
• The property must have a useful life that exceeds one year.

Now, let's put this information to work and review a few things investors should know when claiming depreciation on rental property.

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While investors can claim depreciation of residential and commercial rental properties over a period of 27.5 years and 39 years, respectively, they can never claim depreciation for the value of land. Since land value is not depreciable, the IRS requires investors to allocate the purchase price between the land and the building.

To claim rental property depreciation, investors must first determine the cost basis of the property. To find the cost basis, investors must subtract the value of the land from the purchase price and add any additional costs incurred to obtain the property, which typically include but are not limited to:

• Any mortgage debt assumed by the buyer
• Legal fees
• Transfer taxes
• Pest inspection
• A property survey
• Appraisal fees
• Recording fees

ALSO READ: How to Make a Depreciation Schedule: A Small Business Guide

For rental property that is owned all year, the process of claiming depreciation requires dividing the cost basis of the property over its useful life (27.5 years for residential real estate and 39 years for commercial real estate). Residential rental property investors typically recover 3.636% of the costs per year.

ALSO READ: A Small Business Guide to Bonus Depreciation

In addition to the cost of the building, investors can claim depreciation on the value of the assets inside the rental property. To do this, a cost segregation study needs to be conducted.

As part of the study, the assets will be placed into four categories:

• Personal property
• Land improvements
• Building components
• Land.

Each asset will be assigned a property class and useful life, typically between five and 15 years.

ALSO READ: 6 Rental Property Expenses You May Not Know You Can Depreciate

Investors can claim bonus depreciation for rental property assets (new and used) with a recovery period of fewer than 20 years. This means they can claim 100% of the cost of an asset in a single year rather than spread the cost over the assigned useful life. Ultimately, this means even bigger tax savings.

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Investors who make improvements to a piece of rental real estate can claim depreciation and bonus depreciation for the cost of the improvement. The useful life of an improvement typically ranges between five and 15 years.

Before claiming depreciation for an improvement, investors should ensure the improvement is not actually a repair; repair costs are expensed, not depreciated.

ALSO READ: 4 Ways To Spend Your Renovation Dollars in 2022

When investors sell a rental property, a tax -- called depreciation recapture -- must be paid on any previously claimed depreciation. Depreciation recapture is typically taxed at ordinary income tax rates. Investors claiming depreciation should be aware of this tax and practice careful tax planning when preparing to sell their rental real estate.

Claiming depreciation is a huge perk associated with rental property ownership. With careful planning, claiming depreciation can prove to be a very savvy tax strategy.

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