Rental property investing comes with a number of potential tax benefits for landlords, including the depreciation deduction. I'll get to the 'temporary' part in a bit, but first, it's helpful to understand the basics.

Depreciation is the loss in value of a structure over time due to wear and tear. The IRS allows depreciation on a rental property for a 27.5-year lifespan. This means that you can deduct the amount of depreciation of your rental property each year for that amount of time, if you own it that long, as a depreciation expense.

Let’s say that you buy a single-family home as a rental property investment. To determine what your depreciation deduction looks like for a single year, divide 100 percent by 27.5 years — you come up with 3.636 percent. For each full year of ownership, you can deduct that 3.636 percent of the cost basis of the home as long as it is used as a rental property the entire year.

Determining your cost basis

So, what’s the cost basis of a rental home?  The cost basis is your purchase price minus the value of the land. Land doesn’t depreciate, so you have to break that out of the calculation. If you got an appraisal, it’s likely that the appraiser separately valued the land. Just subtract that from the purchase price to get the structure’s value for depreciation.

If you don’t have an appraisal separating out the land value, you can use the property tax valuation percentage for the building. Since the county tax value is almost never going to be what you paid for it, you use the building’s percentage of the tax valuation.

Here’s an example: If the county assessor has valued your property at $167,000, with $55,000 of that applied to the land, the value of the home would be $112,000 ($167,000 - $55,000). Divide that by the overall value of $167,000 to get a building value of 67 percent of the full amount. Now you have a percentage to work with.

If you paid $184,000 for the property, then $184,000 X .67 gives you a structure cost basis of $123,280. That’s the number you’re depreciating over the 27.5-year period. So, each full year it is in rental service, you get 3.636 percent as a depreciation deduction, or in this example, $123,280 X .03636 = $4,482.

The good news is that you don’t have to spend any extra money to use this tax deduction against your income.

Adjusting for partial years of service

You notice that I keep using the “full year of service” statement: Unless you bought your rental property at the end of the calendar year and put it into rental service on January 1, you’ll need to do a calculation to adjust for that first year of ownership.

This chart is from the IRS, and it gives you the percentage to use based on the month you put the property into rental service. This isn’t broken into days or weeks, so the monthly percentage applies regardless of which day that month it went into service. If you bought a home and closed on it in mid-June, then immediately put it into rental service, you would look at month six and use 1.970 percent as the depreciation deduction for that first year. Using the numbers from the same theoretical purchase above, that’s $123,280 X .01970 = $2,429.

Why is rental property depreciation only temporary?

Maybe you’re cashing out your investment property to fund another pursuit, or you just don’t want to be in the landlord business anymore — whatever the reason, the day comes when you want to sell the home. You invested well, and you’re making a profit on it too! The IRS isn’t looking at the profit over what you initially paid for the home, but they are looking at the amount over the depreciated value.

So, using our original example and making it simple, let’s say you bought the property and put it into service on January 1, and you sold and closed the sale on December 31, six years later.

You owned it for six years, and it was in rental service the entire time. This makes the calculation easier, as we’ve taken six full years of depreciation deductions at 3.636 percent per year, for a total of $26,895 ($123,280 X .03636 X 6). The depreciated value of the home is $96,385 ($123,280 - $26,895).

It’s been a good six years, and you’re selling the property for $195,000. Going back to the percentage of the total value that applies to the structure — 67 percent — the home is worth $130,650 ($195,000 X .67). The IRS wants their depreciation back, so we’re going to pay normal income tax on the difference: $130,650 - $96,385 = $34,265.

Now you know what “temporary” means. You might be thinking, “Why not just avoid taking the depreciation deduction to save on taxes later?” As with many IRS rules, you will pay taxes on the difference anyway, as the IRS will hold you accountable at the time of sale. So, you might as well take the benefit since you’ll still get taxed.

Or, just don’t pay it!

No, you’re not going to jail, and you’re not subject to tax liens. Using the 1031 Tax Deferred Exchange, you can defer this and all capital gains if you roll the money into another investment property. But, that’s another article.