A key tax deduction—namely, the allowance for depreciation works somewhat differently. Depreciation is used to deduct the costs of buying and improving a rental property. Rather than taking one significant deduction in the year you buy (or improve) the property, depreciation distributes the deduction across the useful life of the property.

The Internal Revenue Service (IRS) has particular rules regarding depreciation, and if you own rental property, it’s essential to understand how the process works.

Which Property Is Depreciable?

According to the IRS, you can depreciate a rental property if it meets all of these requirements:

• You own the property (you have considered the owner even if the property is subject to a debt).

• You use the property in your business or as an income-producing activity.

• The property has a determinable useful life, meaning it's something that wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes.

• The property is expected to last for more than one year.

Even if the property meets all of the above requirements, it cannot be depreciated if you placed it in service and disposed of it (or no longer use it for business use) in the same year.

Note that land isn't considered depreciable since it never gets "used up." And in general, you cannot depreciate the costs of clearing, planting, and landscaping, as those activities are considered part of the cost of the land and not the buildings.

When Does Depreciation Start?

You can begin taking depreciation deductions when you place the property in service or when it's ready and available for use as a rental.

Here's an example: You buy a rental property on May 15. After working on the house for several months, you have it ready to rent on July 15, so you begin to advertise online and in the local papers. You find a tenant, and the lease starts on Sept. 1. As the property was placed in service—that is, ready to be leased and occupied—on July 15, you would begin to depreciate the house in July, not in September when you start collecting rent.

You can continue to depreciate the property until one of the following conditions is met:

• You have deducted your entire cost or another basis in the property.

• You retire the property from service, even if you have not fully recovered its cost or another basis. A property is retired from service when you no longer use it as an income-producing property—or if you sell or exchange it, convert it to personal use, abandon it, or if it's destroyed.

You can continue to claim a depreciation deduction for property that's temporarily "idle" or not in use. If you make repairs after one tenant moves out, you can continue to depreciate the property while you get it ready for the next.

How to Calculate Depreciation

Three factors determine the amount of depreciation you can deduct each year: your basis in the property, the recovery period, and the depreciation method used.

Any residential rental property placed in service after 1986 is depreciated using the Modified Accelerated Cost Recovery System (MACRS), an accounting technique that spreads costs (and depreciation deductions) over 27.5 years. This is when the IRS considers a rental property’s “useful life.”

While it’s always recommended that you work with a qualified tax accountant when calculating depreciation, here are the basic steps:

• Determine the basis of the property. The cause of the property is its cost or the amount you paid (in cash, with a mortgage, or some other manner) to acquire the property. Some settlement fees and closing costs, including legal fees, recording fees, surveys, transfer taxes, title insurance, and any amount the seller owes that you agree to pay (such as back taxes), are included in the basis. Some settlement fees and closing costs can’t be included in your cause. These include fire insurance premiums, rent for tenancy of the property before closing, and charges connected to getting or refinancing a loan, including points, mortgage insurance premiums, credit report costs, and appraisal fees.

• Separate the cost of land and buildings. As you can only depreciate the cost of the building and not the ground, you must determine the value of each to decline the correct amount. To determine the deal, you can use the fair market value of each at the time you bought the property, or you can base the number on the assessed real estate tax values. Say you bought a house for $110,000. The most recent real estate tax assessment values the property at $90,000, of which $81,000 is for the home, and $9,000 is for the land. Therefore, you can allocate 90% ($81,000 ÷ $90,000) of the purchase price to the house and 10% ($9,000 ÷ $90,000) of the purchase price to the land.

• Determine your basis in the house. Now that you know the basics of the property (house plus land) and the house’s value, you can determine your cause in the place. Using the above example, your base in the house—the amount that can be depreciated—would be $99,000 (90% of $110,000). Your basis on the land would be $11,000 (10% of $110,000).

• Determine the adjusted basis, if necessary. You may have to make increases or decreases to your base for certain events between when you buy the property and when you have it ready for rental. Examples of increases to basis include the cost of any additions or improvements that have a useful life of at least one year before you place the property in service, money spent to restore damaged property, bringing utility services to the property, and specific legal fees. Decreases to the basis can be from insurance payments you receive due to damage or theft, casualty loss not covered by insurance for which you took a deduction, and money you receive to grant an easement.

How Much Does Depreciation Reduce Tax Liability?

If you rent real estate, you typically report your rental income and expenses for each rental property on the appropriate line of Schedule E when you file your annual tax return. The net gain or loss then goes on your 1040 form. Depreciation is one of the expenses you’ll include on Schedule E, so the depreciation amount effectively reduces your tax liability for the year.

If you depreciate $3,599.64 and are in the 22% tax bracket, you’ll save $791.92 ($3,599.64 x 0.22) in taxes.

The Bottom Line

Depreciation can be a valuable tool if you invest in rental properties. It allows you to spread out the cost of buying the property over decades, reducing each year’s tax bill. Of course, if you depreciate property and then sell it for more than its depreciated value, you'll owe tax on that gain through the depreciation recapture tax.

Because rental property tax laws are complicated and change periodically, it’s always recommended that you work with a qualified tax accountant when establishing, operating, and selling your rental property business. That way, you can be sure to receive the most favorable tax treatment and avoid any surprises at tax time.