How do I depreciate real estate used in my business?

by | Jul 3, 2025 | AI Tax Answer Library, Depreciation & Capital Expenses

Here’s what HIVE AI had to say about “How do I depreciate real estate used in my business?”:

Depreciating real estate used in your business involves specific rules and methods under the Modified Accelerated Cost Recovery System (MACRS). The treatment depends on the type of real property, when it was placed in service, and how it’s used in your business operations.

Basic Requirements for Real Estate Depreciation

To depreciate real estate used in your business, the property must meet fundamental requirements. There shall be allowed as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear (including a reasonable allowance for obsolescence)— (1) of property used in the trade or business, or (2) of property held for the production of income. IRC § 167(a) The property must be owned by you and used in your trade or business or held for the production of income.

The depreciation allowance in the case of tangible property applies only to that part of the property which is subject to wear and tear, to decay or decline from natural causes, to exhaustion, and to obsolescence. The allowance does not apply to inventories or stock in trade, or to land apart from the improvements or physical development added to it. Tresuary Reg. Treasury Regulation None This fundamental principle means that while you cannot depreciate land itself, you can depreciate the buildings and improvements constructed on that land.

Separating Land from Improvements

A critical step in depreciating real estate is properly allocating the purchase price between land and depreciable improvements. Land generally is not depreciable, but improvements or physical developments added to land may be depreciable. If a taxpayer pays a lump sum for property comprising both depreciable improvements and nondepreciable land, she must apportion the cost between the land and the improvements for purposes of calculating depreciation deductions. Dawson U.S. Tax Court Opinions: Evergrow Investments, Inc. Dawson U.S. Tax Court Opinions: Evergrow Investments, Inc. This allocation is essential because only the portion attributable to buildings and improvements can be depreciated.

The allocation between land and improvements should be based on their relative fair market values at the time of acquisition. You can use property tax assessments, appraisals, or other reliable methods to determine the appropriate allocation. This separation affects your depreciation deductions throughout the property’s recovery period.

MACRS Depreciation System

Section 167 generally allows a deduction for the exhaustion and wear and tear of property used in a trade or business or for the production of income. To determine the annual depreciation deduction for the property, taxpayers are required to use the modified accelerated cost recovery system (MACRS) outlined in section 168. Dawson U.S. Tax Court Opinions: Evergrow Investments, Inc. MACRS dictates the applicable depreciation method, recovery period, and convention to use in calculating a depreciation deduction. Dawson U.S. Tax Court Opinions: Evergrow Investments, Inc.

Under MACRS, different types of real property have specific recovery periods and depreciation methods. The system provides standardized rules that eliminate the need to determine actual useful life or salvage value, simplifying the depreciation calculation process.

Nonresidential Real Property

For most business real estate, you’ll use the nonresidential real property classification. If you began using your home for business for the first time in 2024, depreciate the business part as nonresidential real property under MACRS. Under MACRS, nonresidential real property is depreciated using the straight line method over 39 years. IRS – Publication 587: Business Use of Your Home (Including Use by Daycare Providers) This 39-year recovery period applies to office buildings, warehouses, retail stores, and other commercial properties.

The straight-line method means you deduct an equal amount each year over the 39-year period. For example, if you have $390,000 in depreciable basis for a commercial building, you would deduct $10,000 per year ($390,000 ÷ 39 years) before considering any applicable conventions.

Residential Rental Property

If your business involves rental real estate that provides residential housing, different rules apply. For residential rental property MACRS specifically dictates that taxpayers use the straight-line method and a recovery period of27.5 years. Dawson U.S. Tax Court Opinions: Evergrow Investments, Inc. This shorter recovery period reflects the different nature of residential rental property compared to commercial real estate.

Residential rental property includes apartment buildings, single-family rental homes, duplexes, and other properties where people live. The 27.5-year recovery period allows for faster cost recovery compared to commercial property.

Determining Depreciable Basis

The depreciable basis is the amount you can depreciate over the property’s recovery period. To figure the depreciation deduction, you must first figure the part of the cost of your home that can be depreciated (depreciable basis). The depreciable basis is figured by multiplying the percentage of your home used for business by the smaller of the following. • The adjusted basis of your home (excluding land) on the date you began using your home for business. • The fair market value of your home (excluding land) on the date you began using your home for business. IRS – Publication 587: Business Use of Your Home (Including Use by Daycare Providers)

This rule ensures that you cannot depreciate more than your actual investment in the property or more than its fair market value when placed in service for business use. The lower of cost or fair market value rule prevents taxpayers from claiming excessive depreciation deductions.

Business Use Percentage

When real estate is used partially for business and partially for personal purposes, you can only depreciate the business portion. However, if you use property for business or investment purposes and for personal purposes, you can deduct depreciation based only on the percentage of business or investment use. IRS – Publication 225: Farmer’s Tax Guide If you use part of your home for business, you may be able to deduct depreciation on that part based on its business use. IRS – Publication 225: Farmer’s Tax Guide

You must maintain detailed records documenting the business use percentage. For a home office, this might be based on the square footage of the office compared to the total home. For mixed-use properties, you need to track the time and extent of business versus personal use.

Conversion from Personal to Business Use

When you convert personal-use real estate to business use, special rules apply for determining the depreciable basis. The depreciable basis of the property for the year of change is the lesser of its fair market value or its adjusted depreciable basis (as defined in §1.168(b)-1T(a)(4)), as applicable, at the time of the conversion to business or income-producing use.

A, a calendar-year taxpayer, purchases a house in 1985 that she occupies as her principal residence. In February 2004, A ceases to occupy the house and converts it to residential rental property. At the time of the conversion to residential rental property, the house’s fair market value (excluding land) is $130,000 and adjusted depreciable basis attributable to the house (excluding land) is $150,000. Pursuant to this paragraph (b), A is considered to have placed in service residential rental property in February 2004 with a depreciable basis of $130,000.

This example demonstrates that when fair market value is less than adjusted basis at conversion, you use the lower fair market value as your depreciable basis. This prevents taxpayers from claiming depreciation deductions based on a decline in property value that occurred during personal use.

Conventions and Timing

MACRS uses conventions to determine how much depreciation you can claim in the first and last years of the recovery period. For real property, the mid-month convention applies, meaning that regardless of when during a month you place property in service, you treat it as placed in service in the middle of that month.

A depreciates the residential rental property under the general depreciation system by using the straight-line method, a 27.5-year recovery period, and the mid-month convention. Thus, the depreciation allowance for the house for 2004 is $4,137, after taking into account the mid-month convention (($130,000 adjusted depreciable basis multiplied by the applicable depreciation rate of 3.636% (1/27.5)) multiplied by the mid-month convention fraction of 10.5/12).

Alternative Depreciation System

In some cases, you may be required or elect to use the Alternative Depreciation System (ADS). If the taxpayer makes an election under this paragraph with respect to any class of property for any taxable year, the alternative depreciation system under this subsection shall apply to all property in such class placed in service during such taxable year. Notwithstanding the preceding sentence, in the case of nonresidential real property or residential rental property, such election may be made separately with respect to each property. IRC § 168(g)

Under ADS, nonresidential real property is depreciated over 40 years instead of 39 years, and residential rental property is depreciated over 30 years instead of 27.5 years. An election under subparagraph (A), once made, shall be irrevocable. IRC § 168(g) This election might be beneficial in certain tax planning situations or may be required for certain types of businesses.

Section 179 and Bonus Depreciation for Real Property Improvements

While you cannot use Section 179 expensing for the building itself, certain real property improvements may qualify. You may elect to treat qualified real property as qualifying property under Section 179. Qualified real property (i) is qualified improvement property (QIP) described in Section 168(e)(6), and (ii) is any of the following improvements that are made to nonresidential real property and placed in service after the date such nonresidential real property was first placed in service: roofs; heating, ventilation and air-conditioning property; fire protection and alarm systems; and security systems. IRS.gov Tax Topics

These improvements can potentially be immediately expensed under Section 179 rather than depreciated over the building’s recovery period, providing significant tax benefits for qualifying improvements.

Record-Keeping Requirements

Proper documentation is essential for claiming real estate depreciation deductions. To prove entitlement to a depreciation deduction, a taxpayer must also establish the property’s depreciable basis by substantiating its cost, recovery period, and any previous allowable depreciation. Dawson U.S. Tax Court Opinions: Estate of David F. Burbach, Deceased, Cheryl R. Huggins, Personal Representative You must maintain records showing the property’s cost, the date it was placed in service, the business use percentage, and any improvements made to the property.

Belcik may not deduct depreciation for the warehouse because he has not established his cost basis. Moreover, depreciation is based on the taxpayer’s cost basis in the property, not the property’s fair market value. Dawson U.S. Tax Court Opinions: Joseph Belcik This case emphasizes the importance of maintaining proper documentation to support your depreciation claims.

Limitations and Special Rules

Several limitations may affect your ability to claim real estate depreciation deductions. The amount of depreciation computed under section 168, however, may be limited under other provisions of the Internal Revenue Code, such as, section 280A. Section 280A limits home office deductions, including depreciation, to the income generated by the business use of the home.

The deduction for business use of your home is limited to the gross income from the business or rental use of the unit, reduced by the sum of the percentage of the otherwise deductible mortgage interest, real estate taxes, losses from casualty and theft, and deductions allocable to the business or rental activity but not allocable to the use of the unit itself. Expenditures required for the activity but not allocable to the use of the unit itself, such as expenditures for supplies and compensations paid to other persons, are not subject to the gross income limitation. IRS IRM 4.10.10 Standard Paragraphs and Explanation of Adjustments

Recapture Considerations

When you eventually sell business real estate, you may be subject to depreciation recapture rules. In addition, a taxpayer cannot exclude the gain up to any depreciation allowed or allowable as a deduction for periods after May 6, 1997. IRS IRM 4.10.10 Standard Paragraphs and Explanation of Adjustments This means that depreciation deductions claimed on business real estate will generally be recaptured as ordinary income when the property is sold, even if the overall gain qualifies for capital gains treatment.

Planning Considerations

The depreciation of business real estate requires careful planning and consideration of various factors. The choice between regular MACRS and ADS, the proper allocation between land and improvements, and the documentation of business use percentages all affect the amount and timing of depreciation deductions.

Consider the long-term implications of depreciation elections, as they are generally irrevocable and will affect both current tax benefits and future tax consequences when the property is sold. The interaction between depreciation deductions and other tax provisions, such as the passive activity loss rules and Section 280A limitations, should also be evaluated as part of your overall tax strategy.

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