How to Figure a Real Estate Investor's Annual Depreciation Allowance

One of the biggest tax deduction benefits associated with real estate investing is the allowance for depreciation real estate investors are given by the IRS. Primarily because depreciation (known as cost recovery) is a "paper loss" the real estate investor can write off during each year of ownership without having to spend a dime out of pocket.

This is different than taking other legal tax deduction allowances such as mortgage interest because the IRS requires that the real estate investor actually pays out the mortgage interest to someone with hard dollars in order to write it off his or her income taxes. With depreciation allowance no money ever exchanges hands. The real estate investor simply claims the deduction on IRS form 4562.

The Concept

The Internal Revenue Service rightfully concludes that any physical structure, regardless how grand and prestigious a building it may be when it's constructed, has a physical life of just so many years because it eventually will wear out, deteriorate, or become obsolescent. Therefore the IRS concludes that the owner is suffering a financial loss by owning the property and as such should be granted the benefit to recover the cost of that "loss" from his or her income taxes.

As a result, the real estate investor can legally deduct an annual amount for depreciation as cost recovery from the cash flow generated by the asset during the past twelve months of ownership and therein lower his or her income tax liability for that past year.

To do this the tax code classifies all investment real estate into one of the following two categories and then attributes its prescribed useful life to each:

1. Residential. Rental property that derives all or nearly all of its income (i.e., about 80% or more) from dwelling units such as single-family homes, multi-families, apartment buildings, condos and so forth. Prescribed useful life: 27.5 years.
2. Non-Residential. Rental property that derives its income from non-residential sources such as offices, retail space, strip centers, and industrial buildings. We commonly refer to it as commercial real estate. Prescribed useful life: 39.0 years.

Formulation

This illustration considers the formulation for the depreciation allowance taken annually during the holding period and ignores what the tax code calls the "mid-month convention" (applies only to the acquisition and sale years).

Depreciable Basis / Useful Life = Annual Depreciation Allowance

Where,

• Depreciable Basis is the original value of the rental property less the value of the land. Original Value - Land Value = Depreciable Basis
• Useful Life is either 27.5 years (property classified as residential) or 39.0 years (property classified as non-residential).

Example:

You purchased a duplex thirteen months ago for $500,000 of which $100,000 is the designated value of the land. What's your annual depreciation allowance?

1. Depreciable Basis: Original Value - Land Value
   $500,000 - 100,000 = $400,000
2. Useful Life: Since the income is mostly derived from dwelling units, this is a residential property with a useful life of 27.5 years.
3. Result: $400,000 / 27.5 = $14,545

Rule of Thumb

This is only intended to give you an idea about depreciation allowance. We purposely avoided other elements that could become part of the equation such as capitalized costs of acquisition and additions for the sake of simplicity. You should always consult a qualified tax person before making any real estate investment decisions.