Straight-line depreciation is the method the IRS mandates for residential rental property. You divide the depreciable basis of the property (purchase price plus acquisition costs, minus the land value) by 27.5 years. That quotient is the annual deduction you can claim on Schedule E. Commercial property uses a 39-year recovery period instead. The formula is: Annual Depreciation = (Purchase Price + Acquisition Costs - Land Value) / 27.5. Land is never depreciable because it does not wear out, so separating land from structure is one of the first things a good tax advisor will do when you close on a rental.
The reason depreciation matters so much to buy-and-hold investors is that it creates a paper loss against real cash flow. A property might generate $18,000 in net rental income during the year and simultaneously produce a $14,000 depreciation deduction. The investor reports only $4,000 in taxable income despite pocketing $18,000 in cash. This gap between cash flow and taxable income is one of the core wealth-building mechanics of real-estate ownership. High-income investors should also be aware of passive activity loss rules: if your adjusted gross income exceeds $150,000, depreciation losses generally cannot offset W-2 or business income unless you qualify as a real estate professional under IRS rules.
When you eventually sell the property, the IRS recaptures the depreciation you claimed at a maximum rate of 25%, called Section 1250 unrecaptured gain. This recapture tax is separate from the long-term capital gains rate on the remaining appreciation. Investors who plan to hold a property for decades often use a 1031 exchange to defer both the recapture and the capital gains tax indefinitely by rolling proceeds into a like-kind replacement property. Depreciation recapture is the single most overlooked exit cost in real-estate investing, and ignoring it can substantially erode net proceeds at sale.
Worked example
A landlord buys a duplex for $400,000. The county tax assessment allocates 20% of value to land, so the land value is $80,000. The depreciable basis is $400,000 minus $80,000, which equals $320,000. Annual depreciation equals $320,000 divided by 27.5, which is $11,636 per year. If the duplex generates $24,000 in net operating income, the landlord reports only $12,364 in taxable income ($24,000 minus $11,636) despite collecting the full $24,000 in cash. Over the full 27.5-year recovery period, the landlord will have claimed $320,000 in total deductions, all without spending an additional dollar on the property.