How to Depreciate a Rental House You Built on Land You Owned

I still remember my first rental build. I bought a lot for $50,000 and spent $270,000 constructing the house. At tax time, I plugged $320,000 into my depreciation schedule. My accountant stopped me. Land doesn't depreciate. That one conversation saved me from an IRS correction and a corrected return.

The building is your depreciable basis

Depreciation is the tax code's way of acknowledging that a building wears out over time. Land does not. You can't depreciate dirt. So you only depreciate the cost of the structure, plus any site improvements that have a limited life like a driveway or fence. The land cost stays separate forever.

For a residential rental property, the IRS lets you deduct the building cost straight-line over 27.5 years. My house cost $270,000 to build. That number includes materials, labor, permits, architectural fees, and even the temporary power pole. $270,000 divided by 27.5 equals $9,818 per year. That's my annual depreciation deduction.

If I had a driveway or fence, those are site improvements with a 15-year depreciation life, separate from the house. I keep those in a separate column on my spreadsheet. Land is never depreciated, no matter what.

First-year depreciation is prorated

You don't get a full year's deduction when you start renting mid-year. Residential rental property uses the mid-month convention. That means the IRS treats the property as placed in service halfway through the month, no matter what day it actually became available. If I put my house in service in February, I get 10.5 months of depreciation that first year. The math: $9,818 times 10.5 divided by 12 equals $8,591. Every year after that, I claim the full $9,818.

Placed in service means the date the property is ready and available for rent. It doesn't require a signed lease. If I finished construction on February 10 and listed it for rent that same day, February is my placed-in-service month. If I was still painting in February and listed in March, March is the date.

A common mistake is depreciating the full purchase price when you buy an existing property. That's different from building. When you buy an existing rental, you must allocate the purchase price between land and building using the property tax assessor's ratio or an appraisal. Here we built, so the allocation is easier: the land cost is what you paid for the lot, the building cost is all construction costs. But I've seen landlords add the land cost to the building cost accidentally and overstate depreciation. That gets caught in an audit.

If you did any demolition before building, that demolition cost gets added to the land basis, not the building basis. If you paid interest on a construction loan, some of that interest may be capitalized into the building cost. I'm not a tax pro, so I hand my accountant a detailed list of every expense and let him decide where it goes. But the basic rule is simple: only the structure and site improvements with limited lives get depreciated.

What happens when you sell

Depreciation isn't free money. When you sell the property, the IRS recaptures some of the depreciation you claimed. That means part of your gain gets taxed as ordinary income rather than capital gain. For a property held many years, that can be a meaningful tax bill. I set aside a portion of my rental income for that eventual recapture. The land's original cost stays in your basis and reduces your capital gain when you sell. So keep records of both land cost and building cost separately.

I keep a simple spreadsheet with columns for land cost, building cost, date placed in service, annual depreciation, and accumulated depreciation. Every year I add one row. My tax preparer never has to ask me for a single receipt. It also stops me from making the same mistake twice.