Rental Property Depreciation for Landlords

In no short order, rental property depreciation is one of the key benefits of owning investment property and being a landlord. Depreciation of your rental property can substantially reduce the real estate taxable income that is produced by the property.

It's quite possible that by using depreciation, your property could actually produce a positive cash flow and reduce your income taxes at the same time! From an investment standpoint, that's really having the "best of both worlds".

For an official definition, the Internal Revenue Code describes "depreciation deduction" as any reasonable allowance for wear, tear and exhaustion of property used in a trade or business or for the production of income.

The depreciation rules that are in effect when the property is placed in service must be used during the entire life of the asset. For rental property depreciation, the land portion of the real property cost is never depreciable and must be excluded.

Basically, there are two types of depreciation…

• Straight-line Depreciation - The property's "depreciable basis" is taken in equal increments during the useful life (depreciation period) of the asset. Depreciable basis is the original cost of the item. It does not change during the asset's life unless any additional improvements (or capital costs) are made to the asset.

Example: A refrigerator is purchased for $500 and has a depreciation recovery period of 5 years. Using straight-line depreciation, the depreciation for each of the 5 years is $500 / 5 = $100.

• Accelerated Depreciation - This type of depreciation allows for higher depreciation deductions during the initial years of the asset that gradually become reduced during the latter years of ownership. Only certain types of property can qualify for using accelerated depreciation.

"ACRS" and "MACRS" Depreciation Methods

For assets placed in service before 1987, the depreciation method that should be used is the Accelerated Cost Recovery System (or ACRS). Assets placed in service after 1986 must be depreciated using the Modified Accelerated Cost Recovery System (or MACRS). Once a method is chosen, it must be used for the life of the asset.

The major difference between the two depreciation methods is that ACRS specifies a shorter "recovery period" as opposed to the MACRS. With a shorter recovery period, larger depreciation deductions are allowed each year. The Tax Reform Act of 1986 affected investment real estate by introducing the MACRS with longer recovery periods. Landlords purchasing property after 1986 experienced lesser amounts of rental property depreciation than their 1986 predecessors.

Depreciable Property and Recovery Periods for Landlords

As a rental property owner, the types of property used in your landlord business can fall under several different categories besides the building itself. Each category has a specific depreciation recovery period as follows…

• Stoves, refrigerators, carpeting, furniture, dishwashers… This type of property can be depreciated over a 5-year recovery period.
• Computers and peripherals - This category has a 5-year depreciation period.
• Land improvements - fences, shrubbery, sidewalks, paved driveways, landscaping, water pipes, and septic systems. This property has a 15-year depreciation recovery period.
• Cars and Trucks (under 13,000 lbs.) - 5-year depreciation recovery period.
• Office furniture - 7-year recovery period for depreciation.
• Rental property building (residential) - 27.5-year recovery period, and
• Non-residential rental property - 31.5-year recovery if placed in service before May 13,1993, and 39-year recovery period if placed in service after May 12, 1993.

As mentioned above, the raw land portion of the real property is not allowed to be depreciated and cannot be included as part of the real property's depreciation basis.

The good news is that you are allowed to separate the above classes of property and depreciate them separately using IRS Form 4562. Their collective sum can amount to a much greater level of depreciation versus taking the value of the real property, subtracting the raw land cost, and depreciating the resulting cost basis over 27.5 years.

For calculating rental property depreciation, three alternatives can be used under the current tax system…

1. Regular MACRS - This alternative depreciates property in the 3, 5, 7, and 10-year classes using the 200% declining balance (DB) method of depreciation. For 15 and 20-year class property, the 150% DB method is used. The straight-line depreciation method must always be used to depreciate real property, which is 27.5 years for residential and 39 years for non-residential (placed in service after May 12, 1993).

2. Straight-line method over the MACRS recovery period - This method depreciates property at a slower pace than the 200% DB method. It uses a straight-line method and is calculated by dividing the depreciable basis of the asset by the recovery period (in years) for the asset. Recovery periods for the different property classes using this method (straight-line) are the same as the recovery periods using regular MACRS.

3. Straight-line method over the ADS recovery period - The alternative depreciation system has longer depreciation recovery periods than the MACRS. These longer recovery periods (straight-line) are listed in the IRS tables for MACRS. Using ADS makes sense during years where your income is low or you experience losses and the higher MACRS depreciation deductions are not needed.

So, those are the basic concepts of rental property depreciation and how they can be applied to rental operations. For your own particular tax situation, always consult a tax professional for advice.

For more in-depth information and specific examples on rental property depreciation, please visit The Landlord's Library book collection. It's a terrific, one-stop source for practical, comprehensive information on the entire subject of residential landlording.

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