When someone first tipped you off that owning rental property comes with significant tax advantages, you may not have realized that it also comes with some scary math. CPAs love to talk about depreciation as if it’s some sort of magical black box that you need an advanced degree to unlock. While depreciation schedules can indeed get fairly complicated in some situations, 90% of rental property depreciation is actually quite simple.
And then we’ve gone and made it even easier by building a rental property depreciation spreadsheet in Excel that automatically calculates depreciation based on initial acquisition costs, closing costs, renovations prior to placing the asset into service, and financing costs. The Excel model is available as a free download at the end of this post. You’ll want the model because the 10% of rental property depreciation that’s not simple is a total nightmare without Excel.
How Rental Property Depreciation Works
When you buy a physical asset like a vacation rental property, the IRS assumes that its value will slowly decline over time. After all, everything eventually returns to dust, right?
While the classic bungalow you plan to rent out for $3,000/mo (or $300/night on Airbnb) might have been constructed in 1898 and lovingly cared for ever since, you get to assume that it will continue on for exactly 27.5 more years when it comes to filing your federal income taxes. That means that in each full year of ownership, you can assume a paper loss of 3.64% of the value of the physical asset (not the land) in the form of depreciation expense. You take the deduction for depreciation regardless of whether the building is actually deteriorating and even while it’s appreciating in value. 27.5 years is what the IRS has decided is the depreciable lifespan of residential real property and there’s no use in arguing otherwise.
While the building itself (and certain closing costs and renovation expenses) is depreciated over 27.5 years, capital improvements that you make to the property after placing it into service as a short-term rental are depreciable over the “useful life” of the specific improvement. This might be 15 years for a new roof, 5 years for a new dishwasher, and 10 years for new windows. From a practical standpoint, this means that the amount of rental property depreciation expense you can claim in any given year is likely to fluctuate during your hold period.
This is where a detailed schedule comes in handy and we recommend keeping it yourself instead of relying on your CPA. You’ll probably learn a thing or two along the way and reduce your tax prep fees too. Besides, who’s more motivated to make sure you’re getting the maximum deduction for depreciation: you or your CPA who has 50 other clients?
Calculate Depreciation in 4 Steps
1. Determine Your Acquisition Cost Basis in the Building
The first step in calculating rental property depreciation is to allocate your purchase price between the land and structure, since you can’t claim depreciation on land. Most local property tax assessors break down the valuation between land and structure, and you can’t be faulted for using their ratio. For many addresses, the ratio is something like 25/75 or 30/70 land to building. Urban areas generally have higher ratios because the land is so scarce and thus valued higher on a relative basis.
Let’s say you paid $500K for that bungalow and it was most recently assessed at $400K with $100K in the land and $300K in the structure. Since the local tax assessor assumes a 75/25 split, you can do the same and apply the 75% to your full purchase price to arrive at your acquisition cost basis for the building: 75% * $500K = $375K.
You’ve probably noticed that the lower the ratio of land value to building value, the higher your cost basis in the structure will be, which in turn generates a larger depreciation expense and more tax savings. Theoretically, you have the option of using a ratio that’s more aggressive than your local tax assessor, but if you do so you’ll need a formal appraisal or some other documentation to help defend the reasonableness of your calculation to the IRS.
2. Add Allowable Closing Costs
Certain closing costs can be added to your original cost basis, assuming you paid them as the buyer or paid on behalf of the seller and were not reimbursed. The most common of these include:
- Title abstract and owners title insurance fees
- Legal fees
- Recording fees
- Survey costs
- Transfer taxes
You don’t have to allocate closing costs between land and structure since they are specific to your one-time transaction. You simply add them to the original acquisition cost basis in the building and carry on.
Note that costs and fees associated with financing (mortgages and loans) are never added to your basis. Technically, these costs are amortized (not depreciated) separately over the expected life of the loan.
For purposes of our illustration, let’s assume you paid $3,000 for an owner’s title insurance policy, $1,200 in legal fees, $300 in recording fees, and paid no survey costs or transfer taxes for the aforementioned bungalow. Your revised cost basis for the purpose of depreciation is now: $375K + $3,000 + $1,200 + $300 = $379,500.
3. Add Renovation and Other Expenses Incurred Prior to Marketing
The final additions to your original cost basis are rehab and renovation costs for any improvements with a useful life longer than one year, incurred preparing the property to be “placed into service” as a rental. “Placed into service” is the moment the property is ready for paid occupancy, not the first night a paying tenant (or Airbnb guest) actually occupies the property.
Note that advertising fees and costs for minor repairs are both expenses that can be deducted in full in the year incurred. These are not added to your basis when calculating depreciation even if they were paid prior to the property being placed into service.
To continue with our example, let’s say you spent $30K on a new kitchen in the bungalow and another $10K on major roof repairs before listing the property for rent or via Airbnb, VRBO, etc. Your final cost basis for depreciation is: $379,500 + $30K + $10K = $419,500. It doesn’t matter that the kitchen and roof may have useful lives of less than 27.5 years. Since you did the work prior to the property being ready for paying guests, these capital improvements are considered part of your cost basis, not subsequent capital expenditures.
4. Apply the MACRS Depreciation Schedule
Nearly all residential rental property owners are required to use the General Depreciation System (GDS) to calculate how much depreciation expense to take in any given year. GDS specifies that rental property has a 27.5 year useful life, which means that 3.636% of your cost basis in the improvements is depreciable each full year of ownership up until there’s nothing left to depreciate. This assumes you’re using straight-line depreciation, which you should unless you have a compelling reason not to.
Now that we have calculated an adjusted cost basis for the improvements of $419,500, all that remains is to multiple the 3.636% by $419,500, right? That would give us an annual depreciation expense of $15,255, which is correct for each full year that your rental property is in service. But this only works for your first year of ownership if you happened to place your rental property into service on January 1, which almost never happens.
When it comes to depreciation, it turns out that calculating the first and last years correctly is a huge hassle. This is the 10% of rental property depreciation that makes an Excel model a virtual necessity. Fortunately, the IRS publishes a Residential Rental Property GDS table, that specifies how to calculate partial first (and last) year depreciation.
Conceptually, GDS assumes a mid-month convention to calculate partial year rental property depreciation, which leaves us with the following percentages based on the month of the year in which the property was placed into service:
- January: 3.485%
- February: 3.182%
- March: 2.879%
- April: 2.576%
- May: 2.273%
- June: 1.970%
- July: 1.667%
- August: 1.364%
- September: 1.061%
- October: 0.758%
- November: 0.455%
- December: 0.152%
Getting back to our example, let’s say you closed on that bungalow in April and your renovations wrapped up in June. For this partial first year, your depreciation expense will be $419,500 * 1.970% = $8,264. Next year (and in each of the subsequent 25 years) you’ll benefit from the full $15,255 annual depreciation expense we calculated earlier. And if you happen to hang onto this property for more than 27.5 years, your final year depreciation will cover January through November, or 3.636% less 0.152% = 3.484% * $419,500 = $14,615.
Other Rental Property Expenses To Depreciate
It’s rare that an investment property won’t at some point require further investment. After all, most things fall apart given enough time and abuse. Major repairs, replacements, and renovations with a useful life of more than one year are considered capital expenses and are added to your depreciation schedule instead of expensed in the year incurred.
One notable exception is available for work or materials that would normally be capitalized, up to $2,500 per invoice line item, under the IRS’ de minimis safe harbor regulations. Taxpayers that satisfy the requirements can simply expense an unlimited number of these smaller capital project items in the year incurred, even if they have a useful life exceeding one year.
Let’s assume for the sake of argument that you had to replace the roof on the bungalow two years after acquisition at a cost of $22,000. This project clearly does not quality for the de minimis safe harbor exemption so you’ll have to capitalize it. Since it’s an integral part of the structure, you’ll depreciate it over a new 27.5 year period that begins in the middle of the month in which the work was completed (not paid for).
Let’s further assume that you replace the refrigerator in one of the units the following year for $900. That’s clearly under $2,500 so you can simply expense it in the year incurred under the safe harbor regulation. Without the exemption, you’d have to capitalize it over a useful life of 5 years, which would result in depreciation expense of only $180 per full calendar year.
What Are Typical Capital Expenses that Exceed $2,500?
Most major appliances and furniture for short term vacation rentals cost less than $2,500, so you can typically expense these under de minimis safe harbor rules. Some common vacation rental property capital improvements that often exceed this threshold include:
- Large A/C units and furnaces
- Plumbing and electrical systems
- Pools and spas
- Major landscaping
- Windows and doors
Free Excel Model for Rental Property Depreciation
Now that you know how depreciation schedules work in theory, you can use this handy Excel model to accurately calculate a proper depreciation schedule for your residential investment property.
What’s so cool about this spreadsheet?
- Uses GDS straight-line depreciation with mid-month convention per IRS guidelines for real property
- Helps you allocate acquisition cost between land and structure
- Includes handy list of line items to make sure you capture relevant closing costs and renovations in your cost basis
- Automatically totals depreciation expense for each calendar year
- Stylish and intuitive formatting makes it easy to print hard copies
- Tables and auto-calculating cells are locked down to prevent errors