Depreciation

Definition

Depreciation in real estate is the gradual loss of value of a property’s building and improvements over time due to wear and tear, aging, or obsolescence. In accounting and tax terms, depreciation is a deductible expense that lets property owners recover the cost of an investment property over its IRS-assigned useful life (27.5 years for residential rental property; 39 years for commercial property).

Why land vs. building matters

Only the building and depreciable improvements qualify for depreciation—land is not depreciable because it does not wear out. When you calculate depreciation you must separate the purchase price into land value and building/improvement value.

Basic calculation

The most common method is the straight-line method. The formula is:

Annual Depreciation Deduction = (Property Value − Land Value) ÷ Useful Life

IRS useful lives: 27.5 years (residential rental) and 39 years (commercial).

Simple examples

Residential rental example

Purchase price: $200,000. Land value: $30,000. Building value: $170,000. Capital improvements: $10,000, so depreciable basis = $180,000.

Annual depreciation: 180,000 ÷ 27.5 = $6,545 (approx).

If annual rental income is $12,000 and operating expenses are $4,000, net rental income is $8,000. After the $6,545 depreciation deduction, taxable rental income becomes $1,455—reducing income tax owed.

Commercial property example

Purchase price: $500,000. Land: $100,000. Building: $400,000. Useful life: 39 years.

Annual depreciation: 400,000 ÷ 39 = $10,256.41 (approx).

Other depreciation methods & strategies

• Straight-line: Equal deduction each year (most common for real estate).
• Accelerated methods: Allow larger deductions early on (less common for buildings but used for shorter-lived components).
• Cost segregation: A study that separates building components (carpeting, fixtures, landscaping, certain mechanical systems) into shorter recovery classes (5, 7, or 15 years), producing accelerated deductions and higher early-year tax savings.
• Bonus depreciation: Allows immediate deduction of a larger portion of qualifying short-lived assets in the year they’re placed in service (rules vary by tax law year).

Depreciation recapture

When you sell a property, the IRS may tax the portion of the gain attributable to prior depreciation deductions—this is called depreciation recapture. Recaptured depreciation is generally taxed at ordinary income rates up to a capped rate (commonly up to 25% for real property under current rules). Planning for recapture is important when assessing the net after-tax gain on sale.

Benefits of depreciation

• Tax reduction: Lowers taxable rental income each year while the property generates cash flow.
• Improved cash flow: Depreciation can reduce tax owed, improving after-tax returns.
• Accounting accuracy: Matches the expense of using the asset to the income it helps produce.
• Planning tool: Strategies like cost segregation can accelerate deductions to better optimize tax position.

Limitations & considerations

• Depreciation cannot create a loss you can always deduct; passive activity and at-risk rules can limit current deductibility.
• Improvements increase your depreciable basis; repairs are typically expensed, while capital improvements are depreciated.
• Depreciation recapture can produce a significant tax bill at sale—factor it into long-term planning.

Quick checklist for owners

1. Separate land and building values on closing statements.
2. Track capital improvements and their placed-in-service dates.
3. Decide whether a cost segregation study makes sense for accelerating deductions.
4. Plan for depreciation recapture when forecasting sale proceeds and taxes.

Bottom line

Depreciation in real estate is both an economic reality (buildings age) and a tax advantage—an annual deduction that helps property owners recover investment costs over time. Properly calculating and applying depreciation (and planning for recapture) can meaningfully affect cash flow, tax liability, and long-term returns for real estate investors.