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Calculating Depreciation for Residential Real Estate Investments

If you didn’t catch the first part of the TwoWiseAcres quick and dirty guide to taxes for the real estate investor, you might want to check it out. In the first part, I walked through reporting income and expenses for rental properties on Schedule E. In this part, I’m going to cover the basics of depreciation. I’m going to focus on calculating depreciation for the first year of a new investment purchase, but I’ll touch on depreciating capital expenditures incurred later on as well.

If you followed my advice in part one, you should now be well rested and/or liquored up. So, once again, let’s get busy.

Starting to Depreciate a Residential Rental Investment

Depreciation is essentially recovering the cost of an item (or “expensing” an item) over a number of years. To determine depreciation for tax purposes, you have to know three things: the basis, your start date for depreciation, and the depreciation period for the property.

Basis is generally cost. For a rental property, the cost includes a portion of the purchase price, expenses associated with the purchase (i.e. closing costs), and initial rehab or fix-up costs. The “portion” of the purchase price is the portion attributable to the house, and not the land. Since land is not depreciable, you’re required to divide the purchase price between the land and the building by their fair market values. There are a couple of ways to tackle this. First, you can base the allocation of the purchase price between land and building based on the assessed value for property tax purposes. For most, this means that you can go to your county auditor website which will assign a separate taxable value for the land and building and then use the percentage allocation used by the auditor to allocate your purchase price. Second, you can make your own fair market determination, as long as there’s a basis to do so. I use a standard percentage division between land and building of 20% and 80%, respectively, which I pretty much came up with from looking at assessed values to begin with. For those starting out, you’ll want to refer to the tax assessed values for your area rather than just adopt my percentage split.

Depreciating Closing Costs

For the closing costs component, you’ll probably need to refer to your Settlement Statement (or “HUD-1 Form”), but you’ll need to exclude any “pre-paids” that are typically listed as buyer’s expenses, such as pre-paid interest, property taxes, and insurance. Those items will generally be reported as expenses for the year of purchase, so they are not included in the cost basis of the property.

Depreciating Initial Rehab Costs

Fix-up costs include every expense that you incur to put the property in rent-ready condition. This is going to include items spent during the initial fix-up period that might otherwise be treated as current deductible expense items down the road. For example, your rehab will likely involve interior painting, which has to be treated as part of the basis of the property at the outset, but which would be fully deducted in the current year when you re-paint, say, at the time a tenant leaves. Why? Well, that’s what the tax code says.

Determining the Start Date for Depreciation of Rental Property

So now you’ve calculated the basis—i.e. the amount that you’re going to depreciate–now you need a start date. You start depreciating a rental property not when you buy it, but when the property is rent-ready. There’s a little bit of a judgment call here. If you buy it in January, but you’re doing a major rehab into March, then depreciation starts in March. But I almost always find that I have some punch out repairs that might even extend after the property has been rented. So, I’m generally going to pick a start date right around when I can show or advertise the property as a finished product.

For the start date, you actually just need a start month. The IRS helpfully has determined the day during the month that depreciation begins. It’s the 15th. The story goes that the IRS had originally started drafting a complicated set of rules to narrow the start date right down to the day, but got tired and ended up with the 15th, collectively reasoning “close enough.” Now, I could use some fancy IRS terminology like “mid-month convention”, but I’m going to just repeat—it’s the 15th. So if you finish your rehab on March 2, you’re depreciation start date is March 15. Close enough.

Determining the Depreciation or Cost Recovery Period for Rental Property

The last piece in the depreciation puzzle is the depreciation period (or “cost recovery” period in IRS parlance). Here’s where the IRS starts with its explanation:

MACRS consists of two systems that determine how you depreciate your property—the General Depreciation System (GDS) and the Alternative Depreciation System (ADS).

Since the whole purpose of this article is specifically not to use terms like “Modified Accelerated Cost Recovery System,” I’ll just cut to the chase. For the most part, two periods will be applicable to about any depreciable property for residential real estate investing. The first is the depreciation period for the house itself. It’s 27.5 years. This depreciation period also applies to about any major depreciable item that you attach to the house—such as a roof, a major kitchen remodel, window replacement, etc. Then there’s the period that applies to about anything that you put in the house. It’s 5 years. This applies to things like kitchen appliances, carpet, and furniture.

The Depreciation Calculation—the Straight Line Method

Now we have all of the necessary information to do the math. For most, depreciation will be calculated using the straight-line method—which means the depreciation deduction for each full year of depreciation period will be the same. To calculate a year’s depreciation, you divide the cost by the depreciation period. For the year that you start depreciating (as well as the last, when you sell it), you’ll be calculating depreciation based on the partial year. Let’s take our example of the property that was ready for rental on March 2 and assume that the cost including rehab is $100,000.

The annual depreciation amount is $100,000 divided by the depreciation period of 27.5 years which equals $3636.36. For the first partial year, the depreciation amount is calculated for 8 full months plus ½ month for March (if you didn’t catch it before—our start date is the 15th). The calculation is 8.5 months divided by 12 months times the annual depreciation of $3636.36 which equals $2575.76. If you bought some appliances for the home, the calculation is essentially the same but using a 5 year period to determine the annual depreciation.

The depreciation deduction for subsequent years, until the year of sale, will be the annual depreciation amount each year. In the year of sale, the partial year’s depreciation calculation will be the same as the first year’s. That is, you’ll figure the partial year’s depreciation up until the date of sale, but will treat the sale as occurring on the 15th day of the month in which the property was sold. Again, close enough.

Depreciating Capital Expenditures for Rental Property

If you incur a capital expenditure after the year of purchase, such as replacing a roof, the expenditure will be depreciated as a separate item. In other words, for tax reporting purposes, you’ll separately depreciate the roof over a 27.5 year period, calculating depreciation in the same way as you calculated depreciation of the home itself, including using a start date of the 15th day of the month in which the roof was installed.

As a final note, I’ll point out that there are alternatives to using a straight line method of depreciation and alternatives to using the depreciation periods referenced above. Different rules may also apply to property purchased prior to 1986. But this, my friends, is where I hop off the train. If you need more information on depreciation or alternatives available, a tax advisor may be in order. In the meantime, I’ll just wish you all a happy tax freedom day, which I believe falls somewhere in late April these days. Here’s hoping that taking advantage of some depreciation deductions will move it a bit earlier.

{ 13 comments… add one }

  • Ernesto@InsuranceYak.com April 16, 2008, 10:08 am

    Solid article. Nice job on the explanation.

  • Tim Hawkins May 27, 2008, 8:43 pm

    Guys,

    Might I point you to the concept of Cost Segregation (Chattel Analysis)? While you might find most of the companies that can do this for you arn’t interested in SFR’s. I’ve found two companies that can do the work for a resonable fee, try ChattelPros ($795)and ChattelExperts ($645). This article is fairly comprehensive http://www.aicpa.org/pubs/jofa/aug2004/soled.htm
    If you want more detail on the work they did for us, and the actual dollar benefit let me know at timh@cruzio.com

  • Tim Hawkins May 27, 2008, 8:51 pm

    Guys,

    I actually have one more comment for you.

    With regard to the ratio between the building/improvments (depreciable) and land (not depreciable) I’ve found the following information:

    From the IRS Real Property Valuation Guidelines manual (www.irs.ustreas.gov/irm/part4/ch42s06.html), under section 4.48.6.2.4 sub-section (3) approach to value “The valuator should consider the appropriate valuation approaches, such as the market approach, the income approach and the cost approach. Professional judgment should be used to select the approach(es) ultimately used and the method(s) within such approach(es) that best indicate the value of the property.“ So, that sounds like we can use any reasonable method to determine the valuation, and since it doesn’t say we have to determine the improvements first or land first, we get to choose.

    In that IRS manual there is a detailed description of the three methods as follows:
    1. In the Market or Sales Comparison Approach, properties similar to the subject properties sold close to the valuation date are compared to the subject property. Adjustments are made for financing, condition of sale, date of sale, physical characteristics and location to indicate the value of the subject. Care should be taken to consider the number of sales available, their relative comparability, the degree and rationale for adjustments to the sales and the relative correlation and reliability of the value indications from the sales.
    2. In the Cost Approach, an estimated reproduction or replacement cost of the improvements is computed and then reduced for physical, economic and functional depreciation. This value should be computed as of the date of valuation. To this result, an amount is added for the value of the underlying land. This approach is generally useful for specialty properties where other approaches lack sufficient supporting data and where land value and depreciation amounts are reasonably determinable.
    3. In the Income Approach, an income stream is projected based on analysis of historical financial income and expense statements, vacancy rates, rent rolls and terms of existing leases. Value is derived by converting net income/cash flow projections to present value using an applicable capitalization technique reflective of typical investors for the type of property in question. Care should be taken to justify and support projections of income and expenses including any unusual or non-recurring items. Adjustments to income and expense data should be made as necessary to reflect the appropriate income streams consistent with the valuation methodology selected. All discount/capitalization rates should be justified with reliable market data, industry surveys or market supported technical methodology and computations.

    And, the Every Landlord’s Tax Deduction Guide says:
    “…However, improvement ratios determined from a property tax assessment often do not reflect reality. County tax assessors aren’t greatly concerned about arriving at an accurate breakdown of the relative values of your land and improvements. This is because it has no effect on your property tax bill – your tax is based on the total assess value of your property. Often, county assessors apply a standard percentage to all property in the area…As a general rule, tax assessor improvement ratios are on the low side.…”

    And, IRS publication 527 Residential Rental Property says:
    Depreciation “Land and buildings. If you buy buildings and your cost includes the cost of the land on which they stand, you must divide the cost between the land and the buildings to figure the basis for depreciation of the buildings. The part of the cost that you allocate to each asset is the ratio of the fair market value of that asset to the FMV of the whole property at the time you buy it.” It goes on to say “If you are not certain of the FMV of the land and the buildings, you can (doesn’t say you must) divide the cost between them based on their assessed values for real estate tax purposes.”

    Based on that, I’ve researched into raw land of simular size to our 7 brand new homes in MS and AL and have improved the ratio from the questionable standard of 15-20% to a more appropriate 3%. YMMV.

    If you have questions beyond what I specified above, let me know.

  • emily April 20, 2009, 5:49 pm

    i would like to know how to calculate depreciation for a residential property without rental purposes.

  • Mike-TWA April 24, 2009, 6:57 pm

    Emily, If your question is how you calculate depreciation on your residence, the answer is you can’t deduct depreciation on your residence. If I’ve misunderstood what you’re looking for, leave another comment and I’ll try to help.

  • Winkle May 12, 2009, 4:09 pm

    O.K., this is all easy and neat. What if you have a rental property with multiple living units and an owner-occupancy? Actually, the bigger question I had involves the fact that the basis was never determined or used in prior years. So, does one have to go back to the original purchase to establish current basis, or can one begin basis at any year? We’re talking of a property originally purchased 20 years ago, when values aren’t near what it would be in recent years.

    I know, why not. Let’s not ask that.

  • Winkle May 12, 2009, 4:11 pm

    Probably should add there’s been a couple of refinancings in there, too.

  • Debbie Barratti October 24, 2009, 7:11 am

    Why can I not have the replacement window tax credit for a home in which I plan to live in. It is a rental proprerty but I live in an aprt. This will be my primary place of residence when I retire. I still plan getting the windows before the end of the year. Is there anyting else I need to know. I am new at this and I have only had the home for one year.

  • Damien February 10, 2011, 1:24 am

    Winkle, this thread is stale, but figured I would give it a shot anyway. Standard disclaimer: do your research and consult a qualified tax professional before making any decisions. Now that that is done: The IRS forces you to depreciate rental property each year, regardless of whether you actually did so on your schedule E. For a personal unit in a multi-unit dwelling, you would need to segregate out which portion of the entire building is personal (not depreciable) from the rentals. If there are 4 units of equal size, 75% of the building basis (see the article above) would be depreciable. Based on your responses above, it sounds like you have not taken depreciation. Bad news. When you sell the property, the IRS is going to ‘recapture’ the depreciation you were SUPPOSED to take at a (potentially) higher rate of taxation. I would contact a professional tax accountant and see what you can do to capture the depreciation forgone up until now.

  • gary r. February 28, 2011, 2:12 am

    Question Please.

    I sold my rental in 2010
    I rented it out Oct. 2008 …for a total of 3 months
    I rented it all of 2009
    I rented it out till April 7th of 2010….a total in this year of a little over 3 months.
    I never depreciated…IRS says I have to put a deprecation number in column E , form 4797—to add to my basis…..dumb me never thought depreciation was mandatory.

    So…can I fill out form 3115 and just catch up on the total for the required amt.? …to put on my form 4797….column E? I do not want to go back 2 years and redo a form 1040X
    I of course took a 23k loss in this terrible market just to get out of the collapse in my area.
    And, damn lucky to find any buyer.

    • gary r. March 8, 2011, 7:51 pm

      Done,……too easy,…….tel. conference with IRS, let me just figure what total depreciation should have been, and I had the figure to enter on column E.

      The 23 K loss wiped out any taxes I would have paid for the year, so my withheld tax is all coming back home.
      Not good for uncle sam…..this is being repeated thousands of times.

  • lisa dimercurio July 19, 2011, 11:31 am

    My tax person depreciate my rental property at $600k. In 2009 as rental. I told him I paid $400000 in 2006. I switch tax person, new guy said I should depreciate building only $258000. What should I do, correct building value 2010 to $258k and irs doesn’t catch it.

  • Carl March 21, 2012, 10:29 pm

    The article explains depreciating the property but what about the closing costs?

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