Depreciation of Rental Real Estate Property

• Buildings, improvements, appliances, landscaping and major expenses, such as a new roof, are subject to depreciation. The land on which the building sits is not depreciable. The theory behind the depreciation allowance is that these assets have a limited period during which they're useful, after which they lose all or part of their value. Usually, you are not allowed to deduct the cost of these assets completely in the year you purchase them, because their useful lives are longer than one year. In this way, you recover a portion of the costs each year over their useful lives. The depreciation allowance is a reserve account for the restoration or replacement of these assets when necessary. You should take all allowable deductions on your rental property, including depreciation expense, to minimize your tax liability.
  
  

MACRS Depreciation

• Each type of depreciable asset has a different recovery period under the modified accelerated recovery system, or MACRS. Buildings and improvements have a 27.5 year recovery period. Appliances and furnishings, such as stoves, refrigerators, washing machines, dryers, carpeting, flooring and furniture have a recovery period of five years. Landscaping, such as shrubbery and trees, fencing and major replacement projects, such as a new roof, a furnace, plumbing pipes and fixtures, have a recovery period of 15 years. Any replacement project that does not fit into one of these categories has a recovery period of seven years. MACRS is the most commonly-used depreciation method, but there are also alternative depreciation methods that you can use, depending on when the property was placed in service.
  
  

Section 179 Special Depreciation

• There are some circumstances that allow a higher depreciation expense in the first year certain residential real estate property is placed in service. You may be able to expense real property assets other than residential buildings, residential building improvements and land improvements under IRS Code Section 179. After 2009, you can expense 100 percent of qualifying property, subject to the current income limitations and the Section 179 limitation -- which is $500,000, as of 2011.
  
  

Selling or Disposing Rental Real Estate Property

• When you sell rental real estate property, you must deduct allowable depreciation from your basis in the property, even if you did not take the depreciation expenses each year. The IRS requires this reduction for allowed or allowable depreciation. To compute your adjusted basis in the property, add the cost of the property plus the cost of improvements less accumulated depreciation. For example, if you purchased the property for $250,000 and all improvements and other additions were $100,000, the unadjusted basis is $350,000. If the maximum allowable depreciation you could have taken is $150,000, your adjusted basis is $200,000. If you didn't take depreciation when it was available, you lost $150,000 of deductions over the years you owned the property.
  
  

Capital Gains

• You must also pay capital gains tax on the accumulated depreciation of rental property if you sell it at a profit, even if you didn't deduct the depreciation expenses. Using the previous example, let's say your adjusted basis is $200,000. If the property sells for $400,000, the taxable gain is $200,000. This formula applies whether you took the depreciation expense each year or not. If you didn't take the depreciation expense when it was available, you are paying capital gains tax on expenses you never deducted.