The investor's guide to rental home depreciation

What is depreciation?

One of the most advantageous deductions for rental homeowners is depreciation – it allows you to recover your investment over the lifespan of the home by spreading out your cost and offsetting your yearly passive income for tax purposes. This article will walk you through the depreciation calculation from beginning to end and explain why, as an investor, it is beneficial to be able to calculate it yourself.

But before we dive in, it is important to know why the IRS has made depreciation available to you as a rental home owner in the first place. I mean, you cannot depreciate your personal use residence, so what is the difference? For decades, the government has enacted policies and written tax code to promote real estate investing because housing – like water and electricity – are essential needs, and the government wants to encourage as much growth from the private sector as possible. The resulting policies give us a very friendly tax code regarding rental homes.

Unfortunately, like most stuff from the IRS, depreciation can get complex. My hope is that after this post you will feel confident enough to calculate depreciation for your 1040. But, even if you hire a professional to do your taxes, it still benefits you to know how to calculate depreciation so you can accurately estimate your net cash flows for any future homes you purchase, or any additions that change the cost basis of your home.

So let’s get to it.

The first step is to calculate your cost basis. This is what you paid for your home, plus any settlement fees and closing costs (these consist of transfer taxes, title insurance, and any legal and recording fees directly related to the settlement of the home).

It is important to note here that the value of your land is not included in your cost basis - accounting conventions say land is never depreciated!

You can find the value of your land and home through several ways. The first is to take a look at your property tax bill, which provides a separate valuation of your land and home. Or, appraisals are often done to determine mortgages, and they will include the valuation of the land. Either way you go, find the relative percentage of the home to total value like this:

Then multiply that percentage by your cost basis to determine that amount that you will depreciate over your home's lifespan.

Finally, you will need to apply the depreciation rate to your cost basis. For the first year, the rate will depend on what month you placed your home in service (or made the home available for rent).

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec (%) 3.485 3.182 2.879 2.576 2.273 1.97 1.667 1.364 1.061 0.758 0.455 0.152

Then, for years 2-18 your rate will be 3.636%

And for years 19-27 your rate will be 3.637%

There are many deductions you can take, but depreciation is the most desirable because it is a non-cash charge - a pure tax benefit. It is an expense that you can write off, that you never actually pay.