In the U.S., real estate is known for appreciating over the long term. But what about the depreciation of real estate? Depreciation of real estate is a tax concept designed to promote investment in real estate, thereby increasing the supply of housing. Bottom line, real estate depreciation can save you money at tax time, increasing the velocity of your real estate investment.

The depreciation of real estate has a history. Depreciation allows you to get a tax break for investing in real estate. Before the Tax Reform Act of 1986, a real estate investor could use a tax concept called the “double declining balance” (DDB) method of depreciation. This would enable the investor to take double the straight-line depreciation in the early years of ownership. Today, we still use the depreciation concept, but it isn’t as attractive as it was before 1986. Now there are two types of depreciation available to residential property investors: straight line and component depreciation.

In straight-line depreciation, there is a linear decline in the value of the property. The IRS considers the useful life, or the “wearing out” period of real estate improvements, to be 27.5 years. When depreciation calculations are applied, you can’t depreciate the value of the land since the land doesn’t “wear out”. Let’s consider an example for a clearer understanding of how this works.

If you purchase a property for $100,000—remember, this is just an example—the first step your accountant will take is to divide up the value between the land and the improvement. There are two ways to figure out how to divide up the value. One is to have an appraisal done. The most common method, however, is to look at the tax assessment. The tax assessment will divide up the total value of the property into land and improvement. Now, back to our example. Let’s say the tax assessor has allocated 20% of the value to land and 80% to improvement. In this example, that would mean 80% of $100,000 or $80,000 would be the number that can be depreciated. Taking the useful life of 27.5 years mentioned above and dividing that into $80,000, gives you a depreciation deduction of $2,909. In addition to the depreciation, real estate taxes and other expenses of the property can offset rental income. The bottom line is that real estate, especially in the early years of ownership, will show a loss, which results in a tax deduction and tax savings.

Another form of depreciation is called component depreciation. This form of depreciation is seldom used for one single-family home. It tends to be utilized for multi-unit properties. In component depreciation, you break down the property into items that have shorter useful lives. For example, in a 20-unit apartment building you would have 20 refrigerators, 20 dishwashers, 20 ranges/ovens, etc. Those items have shorter useful lives than 27.5 years. The result is that you can usually have a higher depreciation number in the early years of the investment. The disadvantage is that you will need to pay for a third-party study to determine the numbers, and this might offset your tax savings. Your tax professional can help you determine which method is better for you.

That was the good news about depreciation. The bad news is a concept called recapture. When you go to sell the property, taking depreciation lowers the basis of your property. This is the amount of depreciation you have taken while you owned the property. That means that the amount subject to capital gains tax will be higher. To avoid being taxed on the recapture, be sure to talk to your tax professional about executing a 1031 Exchange for another rental property.

One more bit of bad news. There are limits on the amount of depreciation or passive losses you can take based on your income level. If you qualify for the Real Estate Professional Status, there may be ways to increase the amount that you can depreciate.

Be sure to discuss any of these concepts with your CPA or tax professional to determine how the real estate depreciation rules affect you personally.

By Duane Duggan. Duane has been a Realtor since 1982. Living the life of a Realtor and being immersed in real estate led to the inception of his book, Realtor for Life. For questions, e-mail DuaneDuggan@boulderco.com, call 303.441.5611 or visit BoulderPropertyNetwork.com.