Splitting land from building
Only the improvements depreciate. Land does not wear out, so the first step is allocating the purchase price between dirt and structure. Investors commonly start from the county assessor’s ratio — if the assessment says 20% land and 80% improvements, apply that split to what you paid — while an appraisal or a cost segregation study can support a different allocation. The allocation matters more than it looks: a higher building basis means a larger deduction every year for decades, and an aggressive one invites scrutiny. Capitalized closing costs and later capital improvements are added to basis and depreciated as well.
What the deduction is worth
Divide the building basis by the recovery period and you have the annual write-off, taken in equal slices year after year. Because it is subtracted after cash expenses, a property collecting $18,000 with $9,000 of operating costs and $7,000 of mortgage interest can still report a taxable loss once a $6,500 deduction lands on top. That is the mechanism behind the phrase tax-advantaged income. Whether the loss is usable this year is a separate question, since rental losses are generally passive and passive losses can typically only offset passive income.
Annual residential depreciation = building basis ÷ 27.5. On a $220,000 purchase with land valued at $40,000, the $180,000 building basis produces roughly $6,545 a year.
Cost segregation, briefly
A cost segregation study breaks the building into components with shorter recovery periods — appliances, carpet, cabinetry, site work — pulling deductions forward instead of spreading them evenly. On larger properties the acceleration can be substantial; on an inexpensive single-family rental the study can cost more than it returns. Bonus depreciation rules that determine how much of that accelerated amount can be taken immediately have changed repeatedly, so the arithmetic depends on the year and on your circumstances. Price the study against the actual benefit with your CPA.
The catch
Depreciation is a deferral, not a gift. It reduces your basis every year, which enlarges the gain when you sell, and the portion attributable to depreciation is recaptured at its own rate. Investors plan for that in advance — by exchanging, by holding, or simply by setting cash aside — rather than discovering it in the year of sale. The deduction is also mandatory in effect: skipping it does not preserve basis, because recapture is generally computed on what you were allowed to take, so the only thing not claiming it achieves is paying tax twice.
Put it to work
Related terms
- Depreciation recapture — When you sell, the depreciation you claimed — or were entitled to claim — gets taxed back.
- Passive activity loss — Rental losses are generally passive, and passive losses can usually only offset passive income.
- 1031 exchange — A tax-deferred exchange that lets an investor sell one investment property and roll the full proceeds into another like-kind property without recognizing capital gain that year.
- Real estate professional status — A federal tax classification that, when genuinely met, can let rental losses offset ordinary income instead of being suspended as passive.