What is depreciation? I suppose this should have been Part 1, but here we are. The people who wrote tax laws don’t usually want you to take a big tax deduction when you buy and put into service an expensive asset or when you do a big improvement on that asset. And they realize most things have wear and tear and lose value over time. Many businesses have to track the value of assets over time for various accounting and legal reasons. At some point, some people decided to combine all that information and only allow you to deduct some of the cost (we’ll call it cost at this time, it gets complicated) spread out over years.

How many years depends on the asset and what the government has decided is the asset life or what the government will agree is the asset life. For residential rental property that asset life is 27.5 years, IF the property is in the United States. To make things more complicated, when the government says you have to depreciate something instead of taking a full expense deduction, then that is what you have to do, UNLESS they have different rules that apply or that can be applied. But for residential rental property, the actual building, you don’t typically need to worry about that. At this time. Under current law.

Here is the IRS definition of depreciation, found in Pub 946 if you’d like to read more: Depreciation is an annual income tax deduction that allows you to recover the cost or other basis of certain property over the time you use the property. It is an allowance for the wear and tear, deterioration, or obsolescence of the property.

Most of us have or had items that have deteriorated. These items may have deteriorated to a value of zero. I have some shirts like that which my wife would really like me to throw away.

If those shirts were a rental house, depreciated to zero, and if I sell them for zero, I would have zero gain and no taxes owed. And no depreciation recapture owed. But rental houses don’t usually drop to zero value and most are sold with a gain. That is when the depreciation recapture happens, which I discussed some in Part 1. Because the property wasn’t all used up, the government wants some or all of the tax benefit you previously had through depreciation “paid back”.

Note that in most cases you still come out ahead, especially factoring in the time value of money and that in many cases you have more money in the end than what you spent. If you don’t come out ahead then it probably wasn’t a good investment or it might not have been managed properly.

Disclaimer: depreciation and basis are complicated tax topics. I am speaking about what generally applies in the case of residential rental property. Different assets are treated differently. In some cases there are multiple options on how to treat certain assets and improvements. Some industries have different options than other industries regarding depreciation. And the laws do change. Due diligence is required in this tax area to get it right.

In Depreciation Part 3, we will talk about land, which cannot be depreciated. Nearly all real estate has land associated with it.