Depreciation deductions can be an effective way to reduce the taxable rental income you report to the IRS. However, there are reasons not to depreciate your rental property, as claiming the deduction doesn’t always guarantee an income tax savings. A number of other factors, such as the amount of income the property generates and your level of participation in rental activities, significantly affect whether it’s advantageous to claim depreciation.
Increases Taxable Gain
If you anticipate selling your rental property at some point, all of those depreciation deductions you claim in prior tax years will increase the amount of taxable gain you recognize on the sale. Moreover, since your rental properties are not capital assets, the gain is subject to the higher ordinary income tax rates. The reason for the gain increase is that depreciation deductions require you to reduce your tax basis in your rental property, which is equal to its purchase price plus the cost of permanent improvements you make. To illustrate, suppose you purchase a rental property for $100,000 and over a five-year period you claim depreciation deductions totaling $10,000. The result is a decrease to your tax basis of $10,000. Therefore, if you sell the rental property for $120,000, your taxable gain is $30,000 rather than the $20,000 that results when you don't claim depreciation deductions.
Short-Term Rental Use
An exception to the rule allowing you to claim depreciation on rental property applies when you either convert your property into a rental or purchase the property in the same year you resell it. If either scenario applies, you have no choice but to refrain from reporting depreciation deductions on your tax return.
Passive Activity Limitations
Some expenses are deductible from your taxable rental income on Schedule E. These include property taxes, mortgage interest, repairs, expenses to maintain and clean the property, and fees you pay to a management company to handle day-to-day operations of your rental property. If these deductions are sufficient to reduce your taxable rental income to zero or result in the reporting of a loss, claiming a deduction for depreciation will only increase the loss you report. Moreover, the IRS views your rental property as a passive activity, and in most cases it only allows you to deduct the loss from other passive activities that generate income. If your rental property is your sole source of passive income, increasing your loss with depreciation will not provide any tax savings.
Minimal Deduction Amount
Federal tax law requires that you recover your tax basis in the rental property through annual depreciation deductions over 27.5 tax years. If you purchase the property at a low price, your annual depreciation deduction will be relatively small and have a minimal effect on your tax bill. For example, if your annual depreciation deduction is $500, the fees your accountant charges to prepare the additional forms necessary when claiming depreciation can be more than the tax you save with the deduction.
- IRS: Publication 527 -- Residential Rental Property
- Internal Revenue Service. "Tips on Rental Real Estate Income, Deductions and Recordkeeping." Accessed Sept. 30, 2019.
- Internal Revenue Service. "Publication 946, How to Depreciate Property." Accessed Sept. 30, 2019.
- Internal Revenue Service. "Publication 551, Basis of Assets." Accessed March 16, 2020.
- Internal Revenue Service. "Publication 527, Residential Rental Property." Accessed March 16, 2020.
Jeff Franco's professional writing career began in 2010. With expertise in federal taxation, law and accounting, he has published articles in various online publications. Franco holds a Master of Business Administration in accounting and a Master of Science in taxation from Fordham University. He also holds a Juris Doctor from Brooklyn Law School.