Investor · 8 min read
Rental Property Depreciation, Explained
Rental property depreciation is a non-cash tax deduction that lets you write off the cost of a residential rental building over 27.5 years, even in years the property gains value. You divide the building's cost basis (land is excluded) by 27.5 to get your annual deduction, which offsets rental income and often makes a cash-flow-positive rental show a tax loss.
What depreciation actually is
Depreciation is the IRS's way of recognizing that a building wears out over time. Instead of deducting the full cost of a rental property the year you buy it, you spread that cost across the years you own it. The IRS assigns residential rental property a recovery period of 27.5 years under the Modified Accelerated Cost Recovery System (MACRS). Commercial property uses 39 years.
The word 'non-cash' is what makes this deduction powerful. You do not write a check for depreciation. It is a paper expense that reduces your taxable rental income without reducing the cash in your pocket. A rental can send you a positive cash flow every month and still report a loss on your tax return once depreciation is applied.
Only the building depreciates. Land does not wear out, so the IRS does not let you depreciate it. This single rule drives the entire calculation, and it is where most first-time investors make mistakes.
What is and isn't depreciable
Separating the depreciable portion of your investment from the non-depreciable portion is the first step. Land value must be carved out before you calculate anything.
| Depreciable | Not depreciable |
|---|---|
| The residential building (structure) | The land the building sits on |
| Capital improvements (new roof, HVAC, additions) | Routine repairs (deducted in the same year instead) |
| Appliances, carpeting, and fixtures (shorter schedules) | Your personal residence (unless converted to a rental) |
| Landscaping and certain site improvements | The value of your own labor |
To split land from building, most investors use the ratio shown on their county property tax assessment. If the assessor values the land at 25% of total value and improvements at 75%, you apply that 75% to your purchase price plus buying costs to find the depreciable basis.
How to calculate depreciation
The residential formula is straightforward once you have your numbers:
Annual depreciation = Building cost basis / 27.5
Your cost basis is not just the price you paid. It includes the purchase price plus certain closing costs (title fees, recording fees, legal fees, transfer taxes) minus the value of the land. Follow these steps:
- Start with your total purchase price plus qualifying acquisition costs.
- Determine the land-to-building ratio from your county assessment.
- Multiply the total by the building percentage to get your depreciable basis.
- Divide that basis by 27.5.
The IRS uses a mid-month convention, meaning your first and last years are prorated based on the month you placed the property in service. In the middle years, you claim a full 1/27.5 of the basis each year.
A worked example
Say you buy a single-family rental in Riverside for $550,000, plus $8,000 in qualifying closing costs, for a total basis of $558,000. Your county assessment shows land at 20% and improvements at 80% of value.
- Total basis: $558,000
- Land (20%): $111,600 (not depreciable)
- Building basis (80%): $446,400
- Annual depreciation: $446,400 / 27.5 = $16,233 per year
Now assume the property generates $42,000 in annual rent and has $24,000 in operating expenses and mortgage interest. Your cash profit is $18,000. Subtract the $16,233 depreciation deduction, and your taxable rental income drops to just $1,767. You kept $18,000 in cash but are taxed as if you made under $1,800. That gap is the tax efficiency depreciation delivers.
Depreciation recapture at sale
Depreciation is not free money forever. When you sell, the IRS 'recaptures' the depreciation you claimed (or were allowed to claim) and taxes it. Federal depreciation recapture is taxed at a maximum rate of 25%, separate from the capital gains rate on your remaining profit.
Using the example above, if you held the property for 10 years, you would have claimed roughly $162,000 in depreciation. At sale, that $162,000 is subject to recapture at up to 25% federal, which is about $40,500. The rest of your gain is taxed at long-term capital gains rates.
A critical warning: the IRS taxes recapture on depreciation you were allowed to take, whether or not you actually claimed it. Skipping depreciation does not spare you recapture. Many investors defer this liability entirely by using a 1031 exchange to roll gains into a replacement property, or eliminate it through a step-up in basis when the property passes to heirs.
California state tax and cost segregation
California taxes rental income too, and it does not follow the federal rules step for step. The most important difference for investors: California does not conform to federal bonus depreciation. On your federal return you may be able to accelerate large first-year write-offs on qualifying property, but California requires you to depreciate those assets on the standard state schedules instead. You end up keeping two sets of depreciation figures, one federal and one for California's Franchise Tax Board.
California also does not conform to the higher federal Section 179 expensing limits, capping state Section 179 far lower. Because California has no preferential capital gains rate, your gain and recaptured depreciation are both taxed as ordinary income at the state level, which can reach 13.3% for top earners.
Cost segregation is a strategy that accelerates depreciation by breaking a building into components with shorter recovery periods, 5, 7, or 15 years rather than 27.5. An engineer-led study reclassifies things like flooring, cabinetry, and landscaping so more of your basis is written off in the early years. It can meaningfully boost early cash flow, but it increases recapture later and adds cost and complexity. Because of California's non-conformity to bonus depreciation, the state benefit of a cost segregation study is smaller than the federal benefit.
The bottom line
Depreciation is the deduction that makes rental real estate one of the most tax-efficient investments available. By dividing your building basis by 27.5, you shelter rental income year after year using an expense you never actually pay in cash. The tradeoffs are recapture at sale, taxed up to 25% federally, and California's refusal to match federal bonus depreciation, which means more paperwork and a smaller state break.
For California investors, the winning approach is usually to maximize depreciation while you hold, plan for recapture before you sell, and consider a 1031 exchange to defer the bill. Run your numbers with the property's actual assessed land ratio, not a guess.
This article is educational and is not tax, legal, or investment advice. Depreciation rules are detailed and fact-specific. Consult a licensed CPA or tax professional about your situation before filing. Save Financial is a California mortgage brokerage (NMLS #377740, DRE #01875766), not a tax advisor or a bank; we help investors finance and refinance rental property.
About this article: Save Financial is a California-licensed mortgage brokerage (NMLS #377740, DRE #01875766) with offices in Newport Beach and Marina del Rey, serving all 58 counties. We shop multiple lenders to match you with the right program. For a real quote, apply online or call 949-379-5320.