Definition

• Depreciation is a tax deduction for business assets, encompassing everything from buildings to race horses to diesel trucks. Capital improvements to assets, defined as improvements that add value to an asset and have a useful life of at least one year, include tenant improvements like the major remodeling of a kitchen or bath and the replacement of windows, furnaces and roofs. Depreciation is calculated by dividing the cost of the asset or improvement by its useful life, a figure provided by the IRS and dependent on the type of asset and method of depreciation used. Depreciation cannot be used on your personal residence.
  
  

Types of Depreciation

• For tenant improvements made after 1986, there are two depreciation methods from which to choose: GDS (General Depreciation System) and ADS (Alternative Depreciation System). Within the GDS, the tax-payer chooses either straight-line or accelerated depreciation. The ADS system uses only straight-line depreciation, but includes a longer recovery period over which smaller costs are deducted.
  
  

Working Example

• If you have chosen straight-line depreciation under the GDS for a $20,000 kitchen remodel of a rental property, you divide the cost by 27.5 years -- the IRS-identified useful life for this work under this depreciation system. The resulting $727 is deducted as an expense every year for the next 27.5 years.
  
  

Depreciation Recapture

• When you sell a building, 25 percent of the depreciation you have claimed for the building and its capital improvements is recaptured in taxes. If your total depreciation over five years of ownership was $10,000, your tax liability on the depreciation would be $2,500. If you sell your rental property through a 1031, or deferred, exchange in order to buy another rental property, you can avoid this tax unless and until you sell the next building without doing another exchange.
  
  

Benefits

• When you own a rental property, you hope to have a positive cash flow, that is, you hope to have money in your pocket at the end of every month after you have collected the rent and paid all the monthly bills. Without depreciation, you would then pay taxes on the amount of money in your pocket. With depreciation, you can sometimes keep the money in your pocket but, for tax purposes, show a monthly loss because of your depreciation deductions. Depreciation shields income and is one of the many advantages to owning rental property.