What is depreciation and how does it apply to real estate investments?

Depreciation is an accounting method that lets you deduct the cost of an asset over its expected useful life instead of all at once. The idea is that buildings wear out over time, and the IRS allows you to account for that gradual decline in value as a tax deduction each year you own the property.

For residential rental property, the IRS sets the useful life at 27.5 years. That means if you buy a rental house for $300,000 and the land is worth $60,000, you depreciate the remaining $240,000 (the building portion) over 27.5 years. That works out to roughly $8,727 per year in depreciation expense that reduces your taxable rental income. Commercial real estate uses a 39-year schedule, which means a smaller annual deduction spread over a longer period.

The reason real estate investors pay so much attention to depreciation is that it reduces taxable income without requiring you to spend any money. It’s a paper expense. You might collect $24,000 in rent and have $12,000 in actual expenses like insurance, repairs, and property management. That leaves $12,000 in net income. But after applying $8,727 in depreciation, your taxable income drops to $3,273. You still have the cash, you just don’t owe taxes on most of it.

One critical detail is that land cannot be depreciated. Only the building and certain improvements qualify. When you purchase a property, you need to allocate the purchase price between land and building. The IRS will challenge unreasonable allocations, so use the county tax assessment ratio or an appraisal to support your split.

There’s also a concept called cost segregation that accelerates depreciation on specific components of a building. Things like appliances, flooring, landscaping, and certain fixtures can be depreciated over 5, 7, or 15 years instead of 27.5. A cost segregation study identifies these components and front-loads the deductions into the earlier years of ownership. This can make a meaningful difference for investors with higher-value properties.

Depreciation isn’t free money though. When you sell the property, the IRS recaptures the depreciation you’ve taken and taxes it at up to 25%. This is called depreciation recapture under Section 1250. Many investors use 1031 exchanges to defer this tax by rolling proceeds into another investment property, but understanding recapture is important before you sell.

Tracking depreciation correctly from day one matters. Getting the cost basis right, separating land value, and applying the correct method and schedule all affect your tax returns for years. Errors compound over time and create problems when you sell or get audited. Working with a CPA who understands rental property accounting as part of your broader financial strategy helps avoid those problems and ensures you’re capturing every deduction you’re entitled to.