Rental Property Depreciation: What It Is and How to Calculate It

When it comes to maximizing the tax benefits of owning investment property, few tools are as valuable as depreciation. Whether you’re a new landlord or a seasoned investor, understanding how depreciation works can help you reduce your taxable income and improve your overall return.

Let's take a look at what rental property depreciation is, why it matters, and how to calculate it correctly.

What is Rental Property Depreciation?

Rental property depreciation is a tax deduction that allows real estate investors to recover the cost of a property over time. Even though your property may be appreciating in market value, the IRS treats it as a slowly deteriorating asset due to wear and tear, aging, and obsolescence. Depreciation reflects this gradual loss in value and lets you deduct a portion of the property's cost each year from your taxable income.

By taking advantage of depreciation, real estate investors can significantly reduce their annual tax burden while maintaining positive cash flow, making it one of the most powerful tax benefits in rental property ownership.

Understanding Rental Property Depreciation

Rental property depreciation isn’t just a tax break—it’s a reflection of how investment properties function over time. Real estate used for income doesn’t wear out all at once; it provides returns year after year while gradually experiencing wear, aging, and eventual obsolescence. Depreciation allows property owners to match those long-term benefits with an equally long-term expense deduction.

Rather than writing off the full cost of a property in the year it’s purchased, the IRS requires investors to allocate that deduction across the property’s expected useful life. This aligns with a key principle of tax accounting: expenses should be recognized over the same period as the income they help generate.

The rules around depreciation weren’t always so clear-cut. Before the 1980s, property owners had more discretion in estimating how long their assets would last. But that changed with the Economic Recovery Tax Act of 1981, which introduced standardized recovery periods. Just a few years later, the 1986 tax reform locked in the modern framework still in use today, ensuring consistency in how property values are written off over time.

Understanding this system is essential not only for staying compliant but also for making the most of the long-term financial advantages rental properties can offer.

How Does Rental Property Depreciation Work?

Typically, residential rental properties are depreciated over 27.5 to 30 years using the Modified Accelerated Cost Recovery System (MACRS), the standard method required by the IRS. There are two variations of the MACRS, allowing real estate investors to choose which they prefer to use.

General Depreciation System (GDS)

The General Depreciation System (GDS) is the most commonly used method for depreciating residential rental property in the United States. It’s the default system under the MACRS, which determines how assets lose value over time for tax purposes.

Under GDS, residential rental property is depreciated over 27.5 years using the straight-line method. This means you deduct an equal portion of the property’s depreciable basis each year for the entire recovery period. Only the value of the building—not the land—can be depreciated.

For example, if your rental property has a building value of $275,000, you can deduct $10,000 per year ($275,000 ÷ 27.5) as depreciation.

GDS is straightforward, IRS-compliant, and suitable for most rental property owners. It ensures consistent annual deductions, helping investors reduce taxable income and improve cash flow over the long term.

Alternative Depreciation System (ADS)

The Alternative Depreciation System (ADS) is a method of calculating depreciation that uses longer recovery periods and typically results in smaller annual deductions compared to the General Depreciation System (GDS). While GDS is the default method for most residential rental properties, ADS is required in certain situations and may be elected voluntarily in others.

Under ADS, residential rental property is depreciated over 40 years using the straight-line method, instead of the 27.5-year period used under GDS. This means the annual deduction is spread more thinly across a longer time frame, reducing the immediate tax benefits.

You must use ADS if:

• The property is used predominantly outside the United States.
• The property is tax-exempt use property (e.g., owned by certain organizations).
• You're making an election to opt out of bonus depreciation.
• You choose to apply ADS for specific tax planning reasons.

While ADS typically reduces the size of your annual depreciation deduction, it may align better with certain long-term strategies, especially for investors looking to minimize annual losses or avoid passive activity loss limitations.

Before choosing ADS, it’s wise to consult with a tax advisor, as the decision can affect not only your current tax year but also future filings and how depreciation recapture is handled when you sell the property.

Rental Property Depreciation Eligibility Requirements

Before you can claim depreciation on a rental property, it must meet several IRS-defined conditions. These rules ensure that only qualifying investments receive the tax benefits tied to depreciation.

1. You Must Be the Legal Owner

Depreciation is a benefit reserved for property owners—not for renters, lessees, or property managers. Even if the property is financed with a mortgage, as long as you're the legal owner, you may be eligible. Ownership means bearing the risks and benefits of the property, including tax obligations and rights.

2. The Property Must Generate Income

Only properties used for business or income-producing purposes, such as rentals, qualify for depreciation. Personal residences, vacation homes, or second homes used primarily for personal enjoyment typically do not qualify unless they are rented out for a substantial portion of the year under IRS guidelines.

3. The Property Must Be a Physical Structure

Depreciation applies to tangible, permanent structures like houses, apartment buildings, or commercial units. Land itself is not depreciable, as it doesn’t deteriorate or lose usefulness over time in the way buildings do. When calculating depreciation, you must separate the value of the land from the value of the building.

Ensuring your property meets all of these criteria is a crucial first step in claiming depreciation deductions. Misapplying these rules can trigger IRS scrutiny, so when in doubt, seek professional tax advice.

How to Calculate Rental Property Depreciation

Calculating rental property depreciation may sound complicated, but it follows a straightforward formula once you understand the basics. To determine your annual deduction, you'll need to know your property's cost basis, how much of that applies to the building (not the land), and which IRS depreciation method applies. Here's a step-by-step look at how to break it all down.

Figure Out Your Cost Basis

The first step in calculating depreciation is determining your cost basis—essentially, what you paid for the property, including certain acquisition costs. This typically starts with the purchase price, but it can also include expenses like legal fees, title insurance, and recording fees. Keep in mind that your cost basis must be allocated between the land and the building, since only the building can be depreciated. You can often use your property tax assessment or a professional appraisal to estimate the land-to-building ratio accurately.

Calculate the Annual Depreciation

Once you’ve determined your cost basis and separated the value of the land, you’re ready to calculate your annual depreciation deduction. Most residential rental properties use the General Depreciation System (GDS), which applies a 27.5-year recovery period and the straight-line method, meaning you deduct the same amount each year over the life of the asset.

To calculate the annual depreciation:

1. Subtract the value of the land from your total cost basis to get the depreciable basis.
2. Divide the depreciable basis by 27.5 to get your yearly deduction.

For example, if your depreciable basis is $275,000, your annual depreciation would be $10,000 ($275,000 ÷ 27.5).

Note that depreciation starts when the property is placed in service, not when you buy it, so timing matters. In the first and final years, the deduction may be prorated depending on when during the year the property begins or ends rental use. The IRS provides depreciation tables in Publication 527 to help you calculate partial-year deductions accurately.

Apply the Mid-Month Convention

When calculating depreciation for residential rental property, the IRS requires you to use the mid-month convention. This rule assumes that you placed the property in service, or removed it from service, in the middle of the month, regardless of the actual date.

So, if you begin renting out a property on any day in July, the IRS treats it as if it were placed in service on July 15. The result is a half-month’s worth of depreciation for July, followed by full months of depreciation through the end of the year.

The same applies in the final year of depreciation or when the property is taken out of service; only a half-month of depreciation is allowed for that final month.

This convention ensures consistency in reporting and prevents taxpayers from taking a full month's deduction for just a few days of service. When applying the mid-month rule, it’s best to refer to IRS depreciation tables or use tax software that automates the calculation to avoid errors in partial-year depreciation.

How to Report Rental Property Depreciation

Reporting depreciation correctly is essential to staying compliant with IRS regulations and guidelines and ensuring you receive the full tax benefit each year. Depreciation for rental property is reported on Schedule E (Form 1040), which is used to detail income and expenses from rental real estate.

To report depreciation:

1. Complete Part I of Schedule E, where you list your rental income and expenses.
2. Under expenses, include your annual depreciation deduction as a separate line item.
3. You’ll also need to complete Form 4562 (Depreciation and Amortization) in the first year the property is placed in service. This form outlines the method of depreciation, the recovery period, and the amount deducted.

Each year afterward, you continue claiming depreciation on Schedule E without refiling Form 4562—unless you place new depreciable assets into service (like appliances or renovations).

Accurate reporting is crucial, not only for annual deductions but also for correctly calculating depreciation recapture when you eventually sell the property. Improper or missed depreciation can lead to IRS penalties or reduced future tax benefits, so it’s wise to keep detailed records and consult a tax professional if you're unsure.

Depreciation Recapture Explained

While depreciation provides valuable tax savings during ownership, those savings can come back into play when you sell the property—this is known as depreciation recapture. When you sell a rental property for more than its adjusted basis (original cost minus depreciation), the IRS requires you to "recapture" the depreciation you've claimed by taxing that portion of the gain at a higher rate—up to 25%.

In other words, even if your property's market value increased, part of your profit will be taxed differently because you benefited from depreciation during ownership. This doesn’t mean depreciation wasn’t worth it—far from it—but it’s important to plan for the tax impact at the time of sale.

Understanding depreciation recapture helps you make better decisions about when and how to sell, and whether strategies like 1031 exchanges could help you defer those taxes.

Mistakes to Avoid With Rental Property Depreciation

Depreciation can be a powerful tax tool for real estate investors—but only when used correctly. Missteps in calculating or reporting depreciation can lead to lost deductions, IRS penalties, or unexpected tax bills when you sell. Here are some common pitfalls to watch out for:

• Failing to claim depreciation: Even if you don’t claim depreciation, the IRS assumes you did. When you sell, you'll still owe depreciation recapture taxes, meaning you could be taxed on deductions you never actually took.
• Incorrectly allocating land and building values: Only the building portion is depreciable, not the land. Overestimating the building’s value or failing to allocate properly can trigger IRS scrutiny or misstate your tax deductions.
• Using the wrong depreciation method: Most residential rental properties use the General Depreciation System, not the Alternative Depreciation System. Using the wrong method can lead to incorrect deduction amounts and complications down the road.
• Missing the mid-month convention: Depreciation must be prorated in the first and last year using the mid-month convention. Overlooking this can result in claiming more than you're allowed.
• Not keeping detailed records: Improvements, depreciation schedules, and prior-year deductions must be documented accurately. Incomplete records can make tax filing more difficult and complicate things if you’re audited or sell the property.

Avoiding these mistakes helps you stay compliant and maximize the long-term tax advantages of rental property ownership. When in doubt, work with a tax professional to ensure you're following IRS rules properly.

FAQs About Rental Property Depreciation

Explore the frequently asked questions below to learn more about rental property depreciation.

How much can I depreciate a rental property?

You can depreciate the value of the building (not the land) over 27.5 years using the straight-line method under the General Depreciation System. To calculate it, subtract the land value from your total cost basis, then divide the result by 27.5 to get your annual deduction.

What’s the downside of rental property depreciation?

The main downside is depreciation recapture when you sell the property. This means the IRS will tax the depreciation you claimed (or could have claimed) at up to 25%, potentially increasing your tax bill at sale.

Do I have to pay back depreciation on rental property?

Not exactly “pay back,” but when you sell the property, the IRS will tax the amount of depreciation you’ve claimed as ordinary income through depreciation recapture. This can significantly affect your capital gains taxes.

What happens if I don’t depreciate my rental?

Even if you don’t claim depreciation, the IRS assumes you did and will still apply depreciation recapture when you sell. This means you’ll miss out on years of tax savings without avoiding the tax consequences later.

The Final Word on Rental Property Depreciation

Rental property depreciation can reduce your taxable income and improve your investment returns year after year. But understanding how it works—and planning for its long-term impact, including depreciation recapture—is key to making the most of it.

If you're thinking about selling a rental property, consider using a 1031 exchange to defer taxes on both capital gains and recaptured depreciation. To learn more about this strategy, contact the experts at First American Exchange Company today.