Depreciation Real Estate

· 2 min read
Depreciation in real estate is a tax deduction that lets you write off the cost of a building over time — even though the property…

Depreciation in real estate is a tax deduction that lets you write off the cost of a building over time — even though the property is likely going up in value, which makes it one of the best legal tax shelters available.

The IRS says residential rental buildings have a “useful life” of 27.5 years. Commercial buildings get 39 years. So if you buy a rental property and the building (not the land) is worth $275,000, you can deduct $10,000 per year from your rental income for 27.5 years. That’s $10,000 in income you don’t pay taxes on.

How Depreciation Works

You can only depreciate the building, not the land. When you buy a $350,000 property, you need to allocate between land and building. A common split might be 20% land ($70,000) and 80% building ($280,000).

Annual depreciation: $280,000 / 27.5 = $10,182

If your rental income is $24,000/year and your operating expenses are $10,000, your taxable rental income is $14,000. Subtract depreciation ($10,182) and your taxable income drops to $3,818. You collected $14,000 in real cash flow but only pay taxes on $3,818. The rest is shielded.

The Paper Loss Advantage

Depreciation creates a “paper loss” — a tax loss that doesn’t reflect an actual cash loss. Your property might be appreciating 4% annually and generating positive cash flow, but on your tax return, it shows a loss. This is completely legal and is one of the primary reasons wealthy people invest in real estate.

If your total rental losses (including depreciation) exceed your rental income, you might be able to deduct up to $25,000 of that excess against your regular income — but only if your adjusted gross income is under $100,000, with the deduction phasing out between $100,000 and $150,000.

Depreciation Recapture

Here’s the catch. When you sell the property, the IRS “recaptures” all the depreciation you claimed and taxes it at 25%. If you depreciated $100,000 over 10 years, you’ll owe up to $25,000 in depreciation recapture tax at sale.

The workaround? A 1031 exchange lets you defer both capital gains and depreciation recapture by rolling the proceeds into another investment property. Many investors never pay recapture by continuously exchanging into new properties throughout their lifetime.

Bonus Depreciation and Cost Segregation

Cost segregation studies reclassify components of a building (appliances, flooring, landscaping) into shorter depreciation schedules — 5, 7, or 15 years instead of 27.5. This front-loads your deductions dramatically. On a $500,000 property, a cost segregation study might shift $150,000 into accelerated categories, generating massive tax deductions in the first few years of ownership.

Run the numbers on rental property investments using our mortgage calculator, or read the full buying guide for more on investment strategy. Check the glossary for related tax terms.