Depreciation

What it means

Depreciation is the deduction that lets you recover the cost of a rental building a slice at a time, over 27.5 years, rather than all at once in the year you bought it.

The logic behind it is that a building wears out. The IRS does not let you deduct the purchase price of a rental the year you buy it — that would be an enormous one-off deduction for an asset you will own for decades. Instead you spread the building's cost across its "recovery period," which for residential rental property is 27.5 years under the modified accelerated cost recovery system (MACRS). Commercial property uses 39 years.

Two things are true about depreciation that make it unlike every other deduction on Schedule E:

Land is excluded. Land does not wear out, so it never depreciates. You have to split the purchase between land and building, and only the building portion counts.

No money leaves your account. Every other line on Schedule E corresponds to a cheque you wrote. Depreciation does not. It is a deduction you take purely because you own the asset, which is why a rental that put real cash in your pocket can still report a loss for tax purposes.

Why it matters

Depreciation is usually the single largest deduction a small landlord gets, and it is the one most often left on the table.

On a property with a $256,600 building basis, the annual deduction is $9,331. At a 24% marginal rate that is roughly $2,240 of tax you do not pay, every year, for 27.5 years. Nothing else on the form comes close for a typical single-family rental.

It also changes what "profitable" means. A property can generate $11,290 of actual cash and report $1,959 of taxable income, because $9,331 of the difference is depreciation. Landlords who read only their tax return conclude the property is barely working; landlords who read only their bank balance miss that a chunk of that cash is sheltered. Both numbers are real and they answer different questions.

The part that catches people is what happens on sale. The IRS reduces your cost basis by depreciation allowed or allowable — meaning you are treated as having taken the deduction whether or not you actually claimed it. Skip depreciation for ten years and you still pay depreciation recapture tax on it when you sell. There is no version of this where not claiming it works out in your favour.

How it works in practice

Start with what you paid and work down to an annual number.

A property bought for $310,000, with $6,400 of capitalized closing costs and $18,200 of capital improvements since purchase, has an original basis of $334,600.

Now split out the land. The usual method is the ratio on your county tax assessment: if the assessment values land at 23.3% of total, then $78,000 is land and $256,600 is building.

Step	Amount
Original basis	334,600
Less land (not depreciable)	(78,000)
Depreciable basis	256,600
÷ 27.5 years
Annual deduction	9,330.91

That $9,330.91 goes on line 18 of Schedule E every year until the basis is fully recovered.

Two wrinkles worth knowing. The first year is prorated by month using a mid-month convention — a property placed in service in September gets roughly three and a half months' worth, not a full year. And "placed in service" means available to rent, not the day you closed. A property bought in March and listed in June starts depreciating in June.

Improvements made later depreciate on their own schedule, starting when they are placed in service, rather than being folded into the original one. A roof replaced in year four begins its own 27.5-year run in year four.

Common mistakes

• Depreciating the land. The most expensive error on this list. Using the full purchase price overstates the deduction every year and creates a problem that compounds until it is caught.
• Guessing the land split. "About 20%" is not a method. The county assessment ratio is the common, defensible approach; an appraisal is stronger. Whatever you use, keep the document.
• Starting from the closing date. Depreciation starts when the property is placed in service, which is when it is ready and available to rent.
• Forgetting improvements. Each capital improvement adds to basis and gets its own depreciation schedule. Landlords often capitalize the improvement correctly and then never actually claim the resulting deduction.
• Skipping it to avoid recapture. Recapture happens regardless. Not claiming depreciation costs you the deduction and does not save you the tax.
• Assuming it is optional bookkeeping. It is a real deduction with real cash value, and it is the main reason deductible expenses alone understate a rental's tax efficiency.

How BareBones PM helps

Depreciation goes wrong when the inputs are scattered — the closing statement in one folder, the assessment ratio in an email, the roof invoice in a shoebox, and the placed-in-service date in somebody's memory.

BareBones PM holds the depreciation inputs on the property itself: purchase price, capitalized closing costs, the land/building split you used, and the placed-in-service date. The annual deduction is computed from those rather than re-derived each spring, so the figure is the same every year and the reasoning behind it is visible.

Capital improvements are recorded as depreciable assets rather than being lost among ordinary expenses, each carrying its own in-service date and schedule. When a roof goes on in year four, it starts its own run automatically instead of quietly never being claimed.

The year-end tax export then reports the total for line 18 per property, with the assets that make it up listed underneath — which is exactly the breakdown you want on hand if the number is ever questioned.

For the full mechanics including the mid-month convention, see Depreciation for landlords.