Depreciation is one of the biggest tax advantages in real estate investing. It allows property owners to deduct the cost of their investment over time, reducing taxable income and improving cash flow.
What Is Depreciation?
Depreciation is the process of spreading out the cost of a physical asset over its useful life. In real estate, the IRS assumes buildings lose value over time due to wear and tear, even if they’re actually appreciating in market value.
How It Works
For residential rental properties, the IRS sets a depreciation period of 27.5 years. For commercial properties, it’s 39 years. The building’s cost (excluding land) is divided by that number, giving investors an annual depreciation expense.
For example:
- A rental property (excluding land) is worth $275,000.
- The annual depreciation deduction: $275,000 ÷ 27.5 = $10,000 per year.
- This reduces an investors taxable income by $10,000 annually, even though no actual cash was spent.
The Tax Benefits
- Lowers Taxable Income: Depreciation reduces the income reported to the IRS, leading to lower tax bills.
- Offsets Rental Income: Investors can often use depreciation to reduce or eliminate taxes owed on rental profits.
- Bonus Depreciation & Cost Segregation: Special strategies allow for larger upfront deductions by accelerating depreciation on certain property components.
What About Recapture?
When selling a property, the IRS may recapture depreciation deductions, taxing them at the capital gains tax rate, which is commonly lower than an individual’s normal income tax rate.
Continuing the above example:
- The $275,000 property above has been owned for 5 years, reducing the taxable income over those years by $50,000 ($10,000 per year for 5 years).
- The property has a basis of $275,000 – $50,000 = $225,000.
- The property is sold for $325,000, resulting in a capital gain of $325,000-$225,000 = $100,000.
- The $100,000 is taxed at the capital gains (0%-20%) rate rather than the income tax rate (10% – 37%).
Strategies like 1031 exchanges can defer the capital gains tax, if the capital gain is immediately reinvested in a like-kind investment.
Bottom Line
Depreciation is a powerful tax tool that allows real estate investors to shelter income and build wealth. Understanding and leveraging it can significantly enhance investment returns.
Doug Kline, PhD, has held income properties in North Carolina for more than 20 years. He holds a North Carolina broker’s license, and is a member of the National Association of Realtors and the Triangle Real Estate Investors Association. A lifelong learner, he holds an MBA and a PhD in business, and continues his education by attending meetings of the Society of Exchange Counselors and the National Counsel of Exchangors. In addition to his extensive real estate activities, Doug enjoyed a successful career in academia, achieving the rank of Full Professor in the Cameron School of Business at UNC Wilmington. He was honored with research and teaching awards, served as Director of the MS Computer Science and Information Systems program, and was awarded the endowed position Distinguished Professor of Information Systems.