Depreciation is the process used to deduct the costs of buying and improving a rental property. Rather than taking one large deduction in the year you buy (or improve) the property, depreciation distributes the deduction across the useful life of the property.
Real estate depreciation is defined as an income tax deduction that allows a taxpayer to recover the cost (or other basis) of a real estate investment. The depreciation is realized as a type of deduction that reduces the investor's taxable income.
How do you calculate real estate depreciation?
To calculate the annual amount of depreciation on a property, you divide the cost basis by the property's useful life. By convention, most U.S. residential rental property is depreciated at a rate of 3.636% each year for 27.5 years. Any residential rental property placed in service after 1986 is depreciated using the Modified Accelerated Cost Recovery System (MACRS), an accounting technique that spreads cost and depreciation deductions over 27.5 years. This is the amount of time the IRS considers to be the "useful life" of a rental property.
For example a property with a cost basis of $206,000 and divide by the GDS life span of 27.5 years. It works out to being able to deduct $7,490.91 per year or 3.6% of the loan
According to the IRS, you can depreciate a rental property if it meets all of these requirements:
Even if the property meets all of the above requirements, it cannot be depreciated if you placed it in service and disposed of it (or no longer use it for business use) in the same year.
Note that land isn't considered depreciable since it never gets "used up." And in general, you cannot depreciate the costs of clearing, planting, and landscaping, as those activities are considered part of the cost of the land and not the buildings. You can begin taking depreciation deductions as soon as you place the property in service or when it's ready and available to use as a rental.
Depreciation can be a valuable tool if you invest in rental properties, because it allows you to spread out the cost of buying the property over decades, thereby reducing each year’s tax bill.