How to Calculate Real Estate Depreciation

Depreciating acquired real estate correctly can help reduce your income tax liability by lowering your income. Depreciation is considered an annual expense for income tax purposes even though there is not an actual out-of-pocket expenditure each year. Depreciation is based on the original purchase price of the real estate, plus qualified purchase expenses, less land values. Major improvements added later to real estate, such as an addition or new roof, are usually depreciated separately.

Difficulty: Moderate

Instructions

Things You'll Need:

• IRS depreciation guidelines Value of land separated from structures Cost involved in acquisition MACRS schedule, if applicable Calculator

1. Determine the type of real estate that you need to depreciate so you can identify the number of years and type of depreciation to use, according to IRS depreciation guidelines. A link is provided in the Resources section below to IRS depreciation and amortization guidelines. For example, residential rental property is depreciated over 27.5 years, farm buildings are 20 years and qualified restaurant property is 15 years. It must be property that you own. The property must be used in your business or produce income, have a useful life that can be determined and last for more than one year.

2. Add qualified acquisition cost to the purchase price of the property to arrive at the basis used for depreciation. These costs include recording and legal fees, abstract fees, surveys, title insurance and improvements or repairs needed to prepare the property for use. Acquisition cost may also include back taxes or interest paid to acquire clear title from the previous owners. Real estate property Publication 551 contains charges you cannot include in the basis.

3. Deduct the value of the land that the real estate sits on from the depreciable basis of the real estate, unless the land is leased separately. Land cannot be depreciated. Deduct the fair market value of the land for the area in which your real estate is located. If you are not sure what the fair market value of the land is, ask the township or city assessor for current land values.

4. Divide the total basis that you just calculated in the previous steps by the life of the property if you intend to use the Straight Line depreciation method. Prorate the number of months for the year the property is placed into service and the year the real estate is sold or fully depreciated. For example, a rental home placed into service on July 1, with a cost basis of $165,000, using straight-line depreciation over 27.5 years would be calculated like this. $165,000 / 27.5 = $6,000. Depreciation on this property would be $6,000 a year, except for the first year, which would be $3,000 because it was only in service for six months.

5. Multiply the cost basis of the real estate by the percentage indicated by the IRS for other depreciation methods, such as the Accelerated Cost Recovery System (ACRS) and Modified Accelerated Cost Recovery System (MACRS).

Tips & Warnings

• If you are making installment payments to a financial institution, your interest expense is deductible as an expense, but your principal payments are not.
• You cannot depreciate land, so its value must be deducted from the cost of the real estate. Special rules apply for "Liberty Zone," "GO Zone" and Indian reservation-owned property. Real estate used less than 50 percent for business purposes may not qualify.

References

• Depreciation and Amortization
• Overview of Depreciation