How Can I Use Depreciation to Reduce Taxes on Rental Income?

Depreciation is the single most important tax benefit of owning rental property. It allows you to deduct the cost of your building and its components over time, reducing your taxable rental income -- and in many cases creating a paper loss even when your property generates positive cash flow. Understanding how to maximize depreciation is essential for every real estate investor.

How Rental Property Depreciation Works

Under IRC Section 168, residential rental property is depreciated over 27.5 years using the straight-line method under the Modified Accelerated Cost Recovery System (MACRS). Commercial and nonresidential real property uses a 39-year recovery period. You begin depreciating a property in the month it is placed in service -- meaning when it is ready and available for rent, even if it is not yet occupied.

Your depreciable basis is your total cost basis minus the value of the land. Land is never depreciable. If you purchase a rental property for $400,000 and the land is valued at $80,000, your depreciable basis is $320,000. Divided by 27.5 years, that produces an annual depreciation deduction of approximately $11,636. This deduction reduces your taxable rental income dollar for dollar, regardless of how much cash the property actually generates.

Cost Segregation: Accelerating Your Deductions

Standard straight-line depreciation spreads your deduction evenly over 27.5 or 39 years. But a cost segregation study can dramatically accelerate those deductions by reclassifying building components into shorter recovery periods. Items such as appliances, carpeting, cabinetry, and certain electrical and plumbing components qualify as 5-year property. Furniture and fixtures fall into the 7-year class. Land improvements like parking lots, sidewalks, fencing, and landscaping qualify as 15-year property.

On a typical residential rental property, 20% to 35% of the building's value can be reclassified into these shorter-lived categories. Under current law, assets with recovery periods of 20 years or less are eligible for bonus depreciation, which allows you to deduct the full cost of those components in the year the property is placed in service. For a $320,000 depreciable basis where 30% is reclassified -- that is $96,000 -- the entire $96,000 can potentially be deducted in year one instead of being spread over 27.5 years.

Bonus Depreciation Under IRC Section 168(k)

Bonus depreciation has been a moving target in recent years. The Tax Cuts and Jobs Act of 2017 provided 100% bonus depreciation for qualified property placed in service after September 27, 2017. Under the original TCJA schedule, bonus depreciation began phasing down -- 80% in 2023, 60% in 2024, 40% in 2025, 20% in 2026, and 0% in 2027. However, legislative updates may modify this schedule, so investors should verify the current bonus percentage with their CPA before making acquisition decisions.

Depreciation and the Passive Activity Rules

Depreciation deductions are included in your rental activity's net income or loss calculation on Schedule E. If your depreciation creates a net rental loss, whether you can use that loss against other income depends on the passive activity rules under IRC Section 469. Most W-2 earners can deduct up to $25,000 of rental losses if they actively participate and their MAGI is under $100,000. Investors with Real Estate Professional Status can deduct unlimited rental losses, making the combination of REPS and cost segregation particularly powerful.

Depreciation Recapture: The Trade-Off

There is a cost to claiming depreciation. When you sell a rental property, all depreciation claimed (or that could have been claimed) is subject to recapture under IRC Section 1250. Depreciation recapture is taxed at a maximum federal rate of 25%, which is higher than the long-term capital gains rate of 15% or 20% for most taxpayers. This means a portion of your gain on sale will be taxed at the recapture rate regardless of your income level.

However, the time value of money overwhelmingly favors claiming depreciation now and paying recapture later. A $100,000 deduction today at a 37% marginal rate saves $37,000 in current taxes. Even if you pay 25% recapture on that amount when you sell in 10 years, the present value of the future tax is significantly less than the current savings. And if you use a 1031 exchange to defer the sale, recapture is deferred indefinitely.

Every rental property investor should ensure they are claiming all available depreciation. Failing to do so does not avoid recapture -- the IRS recaptures depreciation that was "allowed or allowable," meaning you pay the recapture tax whether you claimed the deduction or not.

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This article is for informational purposes only and does not constitute legal or tax advice. Consult a qualified tax professional regarding your specific circumstances. AE Tax Advisors, 935 Lake Elmo Dr, Suite B, Billings, MT 59105. Phone: (631) 614-5762.