Depreciation is the IRS allowing you to deduct the cost of a building over its "useful life" — even while the property may be appreciating in actual market value. For residential rental property, the IRS assigns a useful life of 27.5 years, which means you can deduct 1/27.5 (3.636%) of the depreciable basis each year as a non-cash expense. On a property with a $250,000 depreciable basis, that is $9,091 per year in deductions that require no cash outflow — reducing your taxable rental income significantly or even eliminating it entirely.

What Can Be Depreciated

The IRS allows depreciation on the structure of the building — not the land it sits on, because land does not wear out. This means your depreciable basis is not the full purchase price:

Depreciable Basis = Purchase Price + Acquisition Costs − Land Value − Non-Depreciable Items Acquisition Costs include: closing costs, legal fees, inspection fees Land Value: use tax assessor's allocation or appraiser's estimate

If the tax assessor values a $400,000 property as 80% structure / 20% land, your depreciable basis is $400,000 × 80% = $320,000 (plus allocable acquisition costs).

In addition to the building itself, certain improvements are depreciable as separate assets with their own schedules:

  • Appliances and personal property: 5-year depreciation
  • Land improvements (landscaping, driveways, fencing): 15-year depreciation
  • Structural improvements: added to the building's basis and depreciated over the remaining 27.5-year schedule

How to Calculate Annual Depreciation

Annual Depreciation = Depreciable Basis / 27.5 Example: $320,000 / 27.5 = $11,636 per year

This is a straight-line calculation — the same amount each year for 27.5 years. The deduction is taken on Schedule E of your tax return for each rental property you own. Use the Rental Depreciation Calculator to determine your exact annual deduction and its estimated tax savings based on your marginal rate.

Passive Activity Rules and the $25,000 Allowance

Rental income and losses are generally classified as passive activity, which means losses can only offset passive income from other sources — not your W-2 wages. However, there is an important exception for active participants: if you actively manage the property (making management decisions, approving tenants, etc.) and your adjusted gross income is below $100,000, you can deduct up to $25,000 of rental losses against ordinary income each year. This phase-out disappears entirely above $150,000 AGI.

Real estate professionals (as defined by the IRS — more than 750 hours per year in real estate activities and more than half your working time) are not subject to passive activity limits and can deduct unlimited rental losses against ordinary income.

Bonus Depreciation and Cost Segregation

Cost segregation is an engineering study that reclassifies components of a building from 27.5-year property to shorter-lived categories (5, 7, or 15-year). Electrical systems, flooring, certain plumbing fixtures, and land improvements may qualify. When combined with bonus depreciation — which allows 60–80% of qualifying assets (depending on the tax year) to be deducted immediately rather than over their scheduled life — cost segregation can generate very large first-year deductions on a newly acquired property.

Cost segregation studies typically cost $5,000–$15,000 for a residential property. They make economic sense when the accelerated deductions are large enough to justify the study cost, which generally means properties with a purchase price above $500,000 or investors in high tax brackets.

Depreciation Recapture on Sale

The tax benefit of depreciation is not permanent — it is deferred. When you sell a rental property, the IRS "recaptures" all the depreciation you claimed by taxing that amount at a special rate of up to 25% (Unrecaptured Section 1250 Gain), regardless of how long you held the property or whether it would otherwise qualify for favorable long-term capital gains rates.

Adjusted Basis = Original Basis − Accumulated Depreciation Gain on Sale = Sale Price − Adjusted Basis − Selling Costs Depreciation Recapture = Accumulated Depreciation × 25% (max) Capital Gain = (Gain on Sale − Accumulated Depreciation) × applicable rate

This recapture is often a surprise for investors who have been claiming depreciation for years. If you have claimed $50,000 in depreciation over the life of ownership, that $50,000 is subject to 25% tax on sale — $12,500 in additional tax. Use the Real Estate Capital Gains Calculator to estimate your full tax liability on a property sale, including depreciation recapture, before deciding whether to sell or hold.