How Depreciation Works on a Rental Property

A deduction for wear that may never happen, on an asset that may be appreciating. It is the strangest number in the model.

27.5 years

The residential schedule. Land is excluded, which is why basis matters.

How this article is scoped

The mechanics below are stable and worth understanding, because they change how you read a return. Whether you can use a paper loss in a given year depends on passive-activity rules, your income and your participation — which is genuinely individual. Confirm your own position with your accountant. Nothing here is tax advice.

The calculation

Annual depreciation = (Purchase price + capitalised closing costs − land value) ÷ 27.5

US residential rental property. Commercial property uses 39 years. Land is never depreciable, because it does not wear out.

The $240,000 example

Purchase price: $240,000
Capitalised closing costs: +$4,000
Total basis: $244,000
Less land value at 20%: −$48,800
Depreciable basis: $195,200
Divided by 27.5: $7,098 per year

$7,098 of annual deduction — seven times the cash flow.

The land allocation is worth getting right

Every dollar allocated to land is a dollar you never depreciate. Many investors default to the county assessor’s land-to-building ratio because it is defensible and documented, though it is not the only accepted method. In high-land-value markets the split can reach 40% or more, which materially changes the deduction — it is worth a conversation rather than a guess.

Why a profitable property shows a loss

Year one, taxable income versus cash

Operating income (NOI with the capital reserve added back): $16,264
Less mortgage interest: −$12,062
Less depreciation: −$7,098
Taxable income: −$2,896
Actual cash flow: +$995

Cash in your pocket, a loss on paper.

Two things drive the gap. Depreciation is a deduction with no cash cost. And your mortgage principal is cash out that is not deductible, while interest — the larger part in early years — is. Note also that a CapEx reserve is not deductible; actual capital spending is capitalised and depreciated on its own schedule, which is why it is added back above.

This is the honest reason a rental with a 1.5% cash-on-cash return is not simply a 1.5% investment. Whether the paper loss is usable in your situation is the part to confirm with your accountant.

The catch: recapture

When you sell, depreciation you claimed is recaptured — taxed as unrecaptured section 1250 gain, at a rate up to 25%, separately from the capital gain on appreciation.

Hold length	Depreciation claimed	Subject to recapture at sale
5 years	$35,491	$35,491
10 years	$70,982	$70,982
20 years	$141,964	$141,964

At $7,098 a year on the example. Recapture applies to depreciation allowed or allowable — not taking it does not avoid it.

“Allowed or allowable” is the trap

Recapture applies to the depreciation you could have claimed, whether or not you did. Skipping the deduction therefore gives up the benefit while keeping the liability — the worst of both. If depreciation has not been claimed on a property you own, that is a conversation to have with an accountant promptly.

Three things that change the picture

Concept	What it does	Worth knowing because
Cost segregation	Splits the basis into components with shorter lives — flooring, appliances, land improvements — accelerating deductions into early years.	It shifts timing, not total deductions, and studies cost money. Generally considered on larger properties.
Passive activity loss rules	Limit when rental losses can offset other income, with a phase-out by income level and different treatment for real estate professionals.	This is why two investors with identical properties can get very different outcomes from the same paper loss.
1031 exchange	Defers both capital gain and recapture into the replacement property's basis.	The deferral is why some investors exchange repeatedly rather than sell.

How to treat it when analysing a deal

Keep it out of the metrics. Cap rate, DSCR, cash-on-cash and IRR are conventionally pre-tax for a good reason: tax treatment depends on the owner, not the property, so mixing it in makes two deals incomparable and makes your analysis useless to anyone else.

Treat it as a separate, personal layer applied after the property decision — real, sometimes substantial, and never the reason to buy something that does not work on its own numbers. Run the property side in the free calculator, and handle the tax layer with someone who knows your return.

Frequently asked questions

How does depreciation work on a rental property?

US residential rental buildings are depreciated straight-line over 27.5 years. You divide the depreciable basis — purchase price plus capitalised closing costs, less the value allocated to land — by 27.5 to get the annual deduction. Land is excluded because it does not wear out.

Can depreciation make a profitable rental show a loss?

Frequently, yes. Depreciation is a deduction with no cash cost, so a property producing positive cash flow can report negative taxable income. Whether that loss can offset your other income depends on passive-activity rules and your circumstances.

What is depreciation recapture?

Tax on the depreciation you claimed, triggered when you sell, charged as unrecaptured section 1250 gain at a rate of up to 25% and calculated separately from the capital gain on appreciation. It applies to depreciation allowed or allowable, meaning skipping the deduction does not avoid the liability.

How much of a property's value is land?

It varies widely by market — commonly 15 to 30%, and considerably more where land is scarce. Many investors use the county assessor's land-to-building ratio because it is documented and defensible, though other methods exist. The allocation matters, since every dollar assigned to land is a dollar you cannot depreciate.

Should depreciation be included in cap rate or cash-on-cash return?

No. Those metrics are conventionally pre-tax, because tax treatment depends on the owner rather than the property. Keeping depreciation out is what makes two deals comparable and what makes your analysis meaningful to a lender or partner.