Definition
Depreciation is the gradual decrease in the value of a property over time due to factors such as wear and tear, aging, or market conditions. In real estate, depreciation is primarily used as a tax deduction for investment properties, allowing property owners to offset income by deducting the cost of the property’s deterioration over its useful life.
Explanation
While depreciation generally refers to a loss in value, it has two different meanings in real estate:
- Tax Depreciation (Cost Recovery): The IRS allows investment property owners to deduct the cost of the property over time, typically over 27.5 years for residential properties and 39 years for commercial properties. This reduces taxable income.
- Market Depreciation: A property may lose value due to declining neighborhood conditions, economic downturns, or physical deterioration. Unlike tax depreciation, market depreciation is not beneficial to the owner.
Formula for Tax Depreciation (Straight-Line Method)
Annual Depreciation = (Property Cost−Land Value) / Depreciation Period
- Property Cost: Purchase price (excluding land).
- Land Value: Land does not depreciate.
- Depreciation Period: 27.5 years (residential), 39 years (commercial).
Example of Tax Depreciation
An investor buys a rental property for $300,000, with the land valued at $50,000. The depreciable building cost is $250,000.
Annual Depreciation = 250,000/27.5 = 9,090.91
The investor can deduct $9,090.91 per year from their taxable rental income, reducing their overall tax liability.