Cost Recovery / Depreciation for Real Estate Investments

If you have purchased property that you intend to rent or converted a previously owner-occupied unit to rental property, you cannot deduct the entire cost of the property in the year in which you purchased it. The Internal Revenue Service, IRS, considers real estate a capital asset, meaning it has a useful life of more than one year. The cost of all capital assets must be allocated over the useful life of the asset as determined by the IRS. Current IRS regulations require you to depreciate all rental property with the Modified Accelerated Cost Recovery System, MACRS. Before you can calculate depreciation for real estate investments, you must determine the cost basis in the asset.

Cost recovery (depreciation) is the periodic allocation of the cost of qualified assets.  When a taxpayer, or in some cases a lessee, purchases a qualified asset they are allowed to recover the acquisition cost of the asset through certain deductions set forth in the Internal Revenue Code.  The method and length of recovery periods depend on the type of property purchased.  The IRS has produced cost recovery tables for the various types of property.

As of the time of this writing (Fall 2013), the following are the current depreciation categories and recovery percentages:

Recovery Percentages for Residential Rental Property
27.5 years

Recovery Percentages for Non-Residential Rental Property
39 years

Recovery Percentages for Land Improvements
15 years

Recovery Percentages for Personal Property
5 years

Sorry, no depreciation is allowed for land

Depreciating Rules for Income Producing Properties

You can recover the cost of income producing properties through yearly tax deductions.  You do this by depreciating the property; that is, by deducting some of the cost each year on your tax return.

Three factors determine how much depreciation you can deduct each year:  1) your basis in the property; 2) the recovery period for the property; and 3) the depreciation method used.  You cannot simply deduct your mortgage or principal payments, or the cost of furniture, fixtures and equipment as an expense.

You can deduct depreciation only on the part of your property used for rental purposes.  Depreciation reduces your basis for figuring gain or loss on a later sale or exchange.

What rental property CAN be depreciated?

You can depreciate your property if it meets ALL the following requirements:

  • You own the property
  • You use the property in your business or income-producing activity (such as a rental property)
  • The property has a determinable useful life
  • The property is expected to last more than one year

Property You Own:  To claim depreciation, you usually must be the owner of the property.  You are considered as owning property even if it is subject to a debt.

Rented Property:  Generally, if you pay rent for property, you cannot depreciate that property.  Usually only the owner can depreciate it.  However, if you make permanent improvements to leased property, you may be able to depreciate the improvements.

Property Having a Determinable Useful Life:  To be depreciable, your property must have a determinable useful life.  This means that it must be something that wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes.

What Rental Property CANNOT be Depreciated?

Certain property cannot be depreciated.  This includes land and certain excepted property.

Land:  You cannot depreciate the cost of land because land generally does not wear out, become obsolete, or get used up.  But if it does, the loss is accounted for upon disposition.    The cost of clearing, grading, planting and landscaping are usually all part of the cost of land and cannot be depreciated.

Although you cannot depreciate land, you can depreciate certain land preparation costs, such as landscaping costs, incurred in preparing land for business use.  These costs must be so closely associated with other depreciable property that you can determine a life for them along with the life of the associated property.

An Example:  You built a new house to use as a rental property and paid for grading, clearing, seeding and planting bushes and trees.  Some of the bushes and trees were planted right next to the house, while others were planted around the outer border of the lot.  If you replace the house, you would have to destroy the bushes and trees right next to it.  These bushes and trees are closely associated with the house, so they have determinable useful life.  Therefore, you can depreciate them.  Add your other land preparation costs to the basis of your land because they have no determinable useful life and cannot depreciate them.

When Does Depreciation Begin and End?

You begin to depreciate your rental property when you place it in service for the production of income.  You stop depreciating it either when you have fully recovered your cost or other basis, or when you retire it from service, whichever happens first.

Placed in Service:  You place property in service in a rental activity when it is ready and available for a specific use in that activity.  Even if you are not using the property, it is in service when it is ready and available for its specific use.

Example 1:  On November 22 of last year, you purchased a dishwasher for your rental property.  The appliance was delivered on December 7, but was not installed and ready for use until January 3 of this year.  Because the dishwasher was not ready for use last year, it is not considered as placed in service until this year.

If the appliance had been installed and ready for use when it was delivered in December of last year, it would have been considered placed in service in December, even if it was not actually used until this year.

Example 2:  On April 6, you purchased a house to use as a residential rental property.  You made extensive repairs to the house and had it ready for rent on July 5.  You began to advertise the house for rent in July and actually rented it beginning September 1.  The house is considered placed in service in July when it was ready and available for rent.  You can begin to depreciate the house in July.

Example 3:   You moved from your home in July.  During August and September you made several repairs to the house.  On October 1, you listed the property for rent with a real estate company, which rented it on December 1.  The property is considered placed in service on October 1, the date when it was available for rent.

Conversion to Business Use:  If you place property in service in a personal activity, you cannot claim depreciation.  However, if you change the property use to business, or the production of income, you can begin to depreciate it at the time of the change.  You place the property in service for business or income-producing use on the date of the change.

An Example:  You bought a home and used it as your personal home for several years before you converted it to rental property.  Although its specific use was personal and no depreciation was allowable, you placed the home in service when you began using it as your home.  You can begin to claim depreciation in the year you converted it to rental property because at that time its use changed to the production of income.

Idle Property
Continue to claim a deduction for depreciation on property used in your rental activity even if it is temporarily idle/not in use.  For example, if you must make repairs after a tenant moves out, you still depreciate the rental property during the time it is not available for rent.

Cost or Other Basis Fully Recovered
You must stop depreciating property when the total of your yearly depreciation deductions equals your costs or other basis of your property.  For this purpose, your yearly depreciation deductions include any depreciation that you were allowed to claim, even if you did not claim it.

Retired from Service
You stop depreciating property when you retire it from service, even if you have not fully recovered its cost or other basis.  You retire property from service when you permanently withdraw it from use in a trade or business or from use in the production of income because of any of the following events:

  • You sell or exchange the property
  • You convert the property to personal use
  • You abandon the property
  • The property is destroyed