What Is Depreciation?
Depreciation is a tax deduction for the theoretical wear and tear on a rental building. Residential property depreciates over 27.5 years (straight-line); commercial over 39 years. You subtract land value first — land doesn't depreciate. A $300,000 property with $50,000 in land gives you ~$9,091/year in deductions. It's a "phantom loss" — no cash leaves your account, but your tax bill drops. When you sell, depreciation recapture claws back some of that benefit at up to 25%.
Depreciation is the IRS allowance that lets you deduct a rental property's building cost (minus land) over 27.5 years — a non-cash expense that lowers taxable income even when the property appreciates.
At a Glance
- Residential rental: 27.5 years straight-line; commercial: 39 years
- Land (typically 20–30% of value) is excluded — only the building depreciates
- Cost segregation can accelerate deductions by reclassifying components into 5-, 7-, or 15-year property
- Bonus depreciation phases down: 80% (2023) → 60% (2024) → 40% (2025) → 20% (2026)
- Recapture at sale: up to 25% on the amount you previously deducted (Section 1250)
Annual Depreciation = Depreciable Basis ÷ 27.5 (residential) or 39 (commercial)
How It Works
The formula. Take your purchase price plus acquisition costs. Subtract the land value — the IRS doesn't let you depreciate dirt. Land allocation usually runs 20–30%; use your appraisal or tax assessor's breakdown. Divide the remaining building basis by 27.5 for residential or 39 for commercial. That's your annual straight-line deduction. A $300,000 property with $50,000 land: $250,000 ÷ 27.5 = $9,091/year. At a 32% marginal rate? ~$2,909 in tax savings annually. No check written. Pure paper.
Phantom loss. Depreciation doesn't touch your bank account. Rent comes in, expenses go out — but the IRS lets you subtract this "wear and tear" from taxable income anyway. That's why a property can cash flow $200/month and still show a taxable loss. The loss is real for taxes; it's phantom for your wallet. Our rental strategy guide walks through how this fits into buy-and-hold.
Cost segregation. A study ($5,000–$15,000 typical) breaks the building into components — carpet, appliances, fixtures, landscaping — and reclassifies them into 5-, 7-, or 15-year schedules instead of 27.5. You front-load deductions. A $1M building might yield $150K–$250K in accelerated assets. With bonus depreciation (40% in 2025, 20% in 2026), you can deduct a chunk of that in year one. Worth it when building cost exceeds ~$500K and you've got income to offset. The tax optimization guide covers when and how.
Recapture. When you sell, the IRS wants some of it back. Unrecaptured Section 1250 gain — the portion of your gain equal to depreciation you claimed — is taxed at up to 25%. The rest of the gain gets long-term capital gains treatment (15% or 20%). A 1031 exchange defers recapture by rolling into like-kind property.
Real-World Example
Memphis duplex. You buy for $320,000. Land allocation: $64,000 (20%). Depreciable basis: $256,000. Annual depreciation: $256,000 ÷ 27.5 = $9,309/year.
Year 1: Rent $28,800, expenses $12,400, mortgage interest $14,200. Taxable income before depreciation: $2,200. Subtract $9,309 depreciation → taxable loss of $7,109. You pocket $200/month in cash flow but show a loss. That loss can offset other income if you qualify as a real estate professional — or it carries forward.
Sell in year 10 for $420,000. You've claimed ~$93,090 in depreciation. Gain = $420,000 − $320,000 = $100,000. Up to $93,090 is recaptured at 25% = $23,273 in recapture tax. The remaining ~$7,000 gain at long-term rates. Or 1031 into a $450K property and defer the whole thing.
Pros & Cons
- Non-cash deduction — lowers taxes without spending money
- Straight-line is simple — divide basis by 27.5, done
- Cost segregation accelerates benefits for larger properties
- Offsets rental income and can offset W-2 (if real estate professional)
- 1031 exchange defers recapture when trading up
- Recapture at sale — you pay back some of the benefit (up to 25%)
- Land allocation is permanent — get it right at purchase
- Cost segregation adds complexity and cost ($5K–$15K)
- Bonus depreciation is phasing out — less benefit for new purchases after 2026
- "Allowed or allowable" — IRS assumes you took it even if you didn't; can't skip and avoid recapture
Watch Out
Skipping the deduction. The IRS "allowed or allowable" rule means they assume you're taking depreciation whether you claim it or not. Skip it and sell later? You still owe recapture on the amount you could have taken. Worst of both worlds — no benefit during ownership, full recapture at sale. Always take the deduction.
Land allocation errors. Overstate land and you under-depreciate for 27.5 years. Understate land and the IRS may challenge at audit. Use an appraisal, tax assessor records, or a cost segregation study. Don't guess.
Cost segregation timing. Best on new acquisitions or major renovations. Running a study on a 15-year-old property you've been depreciating wrong is messier — you're correcting prior years. Get it right at purchase.
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The Takeaway
Depreciation is free money from the IRS — a deduction for wear and tear that doesn't cost you a dime. Take it every year. Plan for recapture at sale, or defer it with a 1031 exchange. For properties over ~$500K in building value, run the numbers on cost segregation. The tax optimization guide ties this into the full stack: depreciation, cost seg, and strategic exits.