Annual Depreciation Allowance: What You Need to Know

Owning real estate can provide investors with a host of tax benefits, but none may be more important than your investment property’s annual depreciation allowance.

Depreciation is a paper loss that real property investors can use each year to lower their annual tax liability. Depreciation allowance varies by property type – it’s 1/39th of the depreciable basis for commercial assets, and 1/27.5th for residential properties. But more on that later. For now let’s start with an overview of annual depreciation allowance and why it can be so important to real estate investors.

What Is Depreciation Allowance?

The IRS allows depreciation of real property used for rental purposes. You can deduct the amount it costs to buy and improve the property over the course of its useful life, a tax break that can reduce your annual taxable income and lower your tax liability.

Many expenses incurred when purchasing a rental property, such as mortgage and other types of insurance, maintenance and repair, home office, property taxes, and many professional services are deductible the year you place the property into service. Depreciation works differently, though.

Depreciation is spread out over the useful life of the asset. For commercial properties that timeline is 39 years, and for residential properties it’s 27.5 years. You can begin taking this deduction the day the asset is placed into service as a rental property. If you close on a tenant-ready asset in the summer but it takes you until fall to get a lease signed, you can begin depreciating the property at the earlier date. If that tenant moves out a year later and you choose to renovate the property, you still can take the depreciation allowance while you are getting the asset ready for another tenant.

There’s a straightforward way to calculate your annual depreciation allowance.

How To Calculate Depreciation Allowance

There are a few methods investors can use to determine depreciation. For simplification we’ll focus on the most commonly used method, straight-line depreciation. This method makes accounting a bit easier because it uses the same amount for depreciation each year the asset is in service.

In order to calculate depreciation using the straight-line method, you use the following formula:

Cost of the asset – residual (salvage) value

Useful life of the asset

The cost of the asset is your basis, which includes the amount you paid to buy the property and any associated expenses or capital expenditures. The residual value is the amount the asset is expected to be worth at the end of its useful life, or the expected time the asset will be placed into service.

Here’s an example of straight-line depreciation: Say you purchased an asset for $1 million and expect it to be worth $200,000 at the end of its useful life of 20 years. Using the formula above, you’ll get the following annual depreciation allowance:

$1,000,000 - $200,000=$800,000 of depreciable costs. $800,000/20 years=$40,000 annual depreciation allowance. That’s a $40,000 tax deduction you can take each year. 

The Bottom Line

Taxpayers that claim depreciation on rental properties must fill out an IRS Form 4562. It’s important to note that any depreciation deductions you take during the holding period of the asset will have to be paid back when you divest the property. This is called depreciation recapture. There are ways to avoid paying this tax liability, however. You can complete a 1031 exchange and reinvest all proceeds from the sale of your original asset into a like-kind replacement asset and defer any capital gains and depreciation recapture taxes. 

It’s a smart move to consult with experienced tax and financial professionals to ensure you are making the proper depreciation allowance deductions, as well as to discuss alternatives to paying capital gains and depreciation recapture taxes when you decide it’s time to divest the asset.