Depreciation can be calculated using either the General Depreciation System (GDS) or the Alternative Depreciation System (ADS). The recovery periods for most property are generally longer under ADS than they are under GDS.
Used when required by law or elected. ADS is used for properties with specific conditions, such as those with tax-exempt use or financed by tax-exempt bonds. ADS is required in the following situations:
ADS can be applied to both nonresidential and residential real property. If you want to use the ADS, you must elect to do so for residential rental property in the first year the property is placed in service. And you can’t change your mind and start using the GDS later. You must use ADS for nonresidential real property, residential real property, and qualified improvement property held by an electing real property trade or business (as defined in IRC §163(j)(7)(B)). For more information, see Revenue Procedure 2019-8 on page 347 of Internal Revenue Bulletin 2019-3, as modified by Revenue Procedure 2021-28 on page 5.
Any property with a recovery period of 10 years or more under the General Depreciation System (GDS) that is held by an electing farming business must use ADS ( IRC §163(j)(7)(C)).
Qualified improvement property held by an electing real property trade or business must use ADS.
If a property is used for qualified business purposes 50% of the time or less, ADS is required.
Property that is used for tax-exempt purposes must use ADS.
Property financed by tax-exempt bonds is subject to ADS.
Property primarily used in farming must use ADS.
These requirements are outlined in the IRC §168(g), which specifies the use of ADS for certain types of property to ensure a slower depreciation schedule compared to GDS. This system is often used to align with specific tax considerations and compliance requirements.
Strategic Tax Implications Depreciation can significantly impact your tax strategy:
By reducing taxable income, depreciation lowers your tax liability. For example, if you own a $550,000 residential rental property, you can deduct approximately $20,000 annually ($550,000 / 27.5 years), reducing your taxable income by this amount.
As a non-cash expense, depreciation enhances cash flow by reducing taxes without affecting actual cash on hand.
Depreciation affects the net income of a property, influencing investment decisions and property valuations.
Consider an individual in California who owns a $1.5 million residential rental property. Using MACRS, they can depreciate the building value (excluding land) over 27.5 years. Assuming the building’s value is $1.2 million, the annual depreciation deduction is approximately $43,636 ($1.2 million / 27.5 years). This deduction can offset rental income, potentially saving over $16,000 in taxes annually, assuming a 37% tax bracket.
Even if your rental property doesn’t generate positive cash flow initially, depreciation can create a paper loss on Schedule E. What you can do with that loss is the catch. Under the passive activity loss rules ( IRC §469, “Passive activity losses and credits limited”), a rental loss generally offsets only passive income. There is a carve-out — with active participation you may deduct up to $25,000 of the loss against ordinary income — but it phases out between $100,000 and $150,000 of modified AGI and is gone entirely above that, which is to say it is worth nothing to most readers of this book. The unused loss is then suspended and carried forward until you have passive income or sell the property.
The two ways a high earner actually puts rental losses against ordinary income are real estate professional status (section “Real Estate Professional Status”), which makes rental activity non-passive subject to strict hour tests, and the short-term-rental route, where materially participating in a rental whose average guest stay is seven days or less takes it outside the passive rules entirely (section “The Short-Term Rental Loophole”). Either way, the depreciation deducted now is recaptured — taxed at up to 25% — when you sell; a paper loss today is partly deferral, not a permanent escape.
When you rent out real estate, you report rental income and expenses on Schedule E of your tax return. This includes costs like repairs, maintenance, and depreciation. Depreciation allows you to deduct a portion of the property’s cost over its useful life, reducing your taxable income. The net gain or loss from Schedule E flows to your Form 1040, impacting your overall tax liability. By depreciating the property, you effectively lower your taxable income, which can be particularly beneficial if you’re in a high tax bracket. This strategy leverages the IRS’s allowance for wear and tear, aligning with IRC §167 and IRC §168. Be mindful of recapture rules under IRC §1250 if you sell the property.
You must use Schedule C to report depreciation on residential rental property if you primarily provide services for your tenant’s convenience, such as regular cleaning, changing linens, or maid service. This is because these activities classify the rental as a business rather than passive income, according to IRS guidelines.
Additionally, you are required to file Form 4562 to report depreciation if you have placed property in service during the tax year.