Key Takeaways
- Depreciable basis = purchase price allocated to building + allocable closing costs (excluding land and financing costs).
- Residential rental: basis / 27.5 years; first and last years prorated by the mid-month convention.
- Capital improvements start their own 27.5-year depreciation schedule from their placed-in-service date.
- The partial disposition election generates an additional deduction when replacing building components—do not overlook it.
Straight-line depreciation is the default method for real estate buildings. While the concept is simple—divide the cost by the useful life—the execution requires careful attention to basis allocation, placed-in-service dates, and the mid-month convention. This lesson covers the mechanics of calculating depreciation correctly.
Allocating Basis Between Building and Land
The first step in depreciation is determining how much of the purchase price is allocable to the building versus the land. Three common methods: (1) Property tax assessment ratios—the county assessor's allocation between land and improvements is the simplest starting point, though not always accurate. (2) Appraisal allocation—a professional appraisal that separately values land and improvements is the most defensible method. (3) Cost approach—for new construction, the actual building cost versus land cost is directly available. Example: A property is purchased for $350,000. The county assessment shows 78% improvements / 22% land. Building basis = $350,000 × 0.78 = $273,000. Land = $77,000. The building basis also includes allocable closing costs (title insurance, recording fees, transfer taxes) but not financing costs (loan origination fees, which are amortized separately). If closing costs add $5,000 to basis, depreciable basis = $278,000.
Annual Depreciation Calculation
For residential rental property, annual straight-line depreciation = depreciable basis / 27.5 years. Using our example: $278,000 / 27.5 = $10,109 per year. However, the first year and last year are adjusted by the mid-month convention. If the property is placed in service in March, you get 9.5 months of depreciation in Year 1 (mid-March through December). First-year depreciation = $10,109 × (9.5 / 12) = $8,003. Year 2 through Year 27: full $10,109 per year. Year 28 (final year): the remaining depreciation—2.5 months' worth ($10,109 × 2.5 / 12 = $2,106). The mid-month convention applies regardless of the actual date within the month that the property is placed in service. Depreciation is calculated on Form 4562 and flows to Schedule E, Line 18.
Depreciation of Improvements and Partial Dispositions
When you make a capital improvement to an existing property (new roof, HVAC replacement, kitchen renovation), the improvement is depreciated separately with its own recovery period starting from the date placed in service. A $15,000 roof installed in Year 5 starts a new 27.5-year depreciation schedule ($545/year). A critical planning opportunity is the partial disposition election: when you replace a building component (e.g., the old roof), you can "dispose" of the remaining undepreciated basis of the old component and deduct it as a loss in the year of replacement. If the old roof had $8,000 of remaining undepreciated basis, the partial disposition election generates an $8,000 deduction in the replacement year—in addition to starting depreciation on the new $15,000 roof. Without this election, the old roof continues depreciating alongside the new one, resulting in an inflated basis with no additional deduction. The partial disposition election is made on the tax return for the year the old component is replaced.
Key Takeaways
- ✓Depreciable basis = purchase price allocated to building + allocable closing costs (excluding land and financing costs).
- ✓Residential rental: basis / 27.5 years; first and last years prorated by the mid-month convention.
- ✓Capital improvements start their own 27.5-year depreciation schedule from their placed-in-service date.
- ✓The partial disposition election generates an additional deduction when replacing building components—do not overlook it.
Sources
Common Mistakes to Avoid
Failing to include capitalizable closing costs in the depreciable basis
Consequence: Underreporting the depreciable basis reduces the annual depreciation deduction by hundreds of dollars per year over the entire recovery period
Correction: Add capitalizable closing costs (title insurance, recording fees, transfer taxes, legal fees) to the purchase price before allocating between land and building
Not taking the partial disposition election when replacing a major building component
Consequence: The old component's remaining basis continues to be depreciated over the original schedule while the new component adds a second layer of depreciation—missing the opportunity for an immediate deduction
Correction: File the partial disposition election (per Treasury Regulation § 1.168(i)-8) when replacing roofs, HVAC systems, or other major components to accelerate the deduction of the old component's remaining basis
Test Your Knowledge
1.How is the depreciable basis of a rental property calculated?
2.What happens to the depreciable basis when a capital improvement is added to a rental property?
3.What is a partial disposition election and when is it beneficial?