What is Depreciation?
Depreciation is the annual non-cash tax deduction allowed against rental property income — residential is depreciated over 27.5 years, commercial over 39. It reduces taxable income without reducing cash flow, the single largest tax advantage of rental real estate.
The IRS treats real property as a wasting asset for tax purposes. Each year you can deduct 1/27.5 of the property's building basis (land doesn't depreciate) against your rental income — even though the building isn't actually wearing out at that rate. The result: your taxable rental income is often lower than your actual cash flow.
Example: $200,000 building basis on a residential rental → $7,272 annual depreciation. Combined with mortgage interest, property tax, and operating expenses, this often pushes the property's taxable income to zero or negative — meaning rental cash flow is largely tax-sheltered.
On sale, depreciation gets "recaptured" at 25% federal — but a 1031 exchange defers this. Sophisticated investors stack 1031 exchanges and rely on stepped-up basis at death to eliminate accumulated depreciation entirely.
Concepts that connect.
Net Operating Income (NOI) is a rental property's annual gross rental income minus all operating expenses, before debt service and income taxes. NOI is the denominator of cap rate and the numerator of DSCR — it's the most-used number in rental underwriting.
Cash-on-cash return is annual pre-tax cash flow divided by the total cash the investor put into the deal (down payment + closing + rehab + reserves). Unlike cap rate, it accounts for financing. The most useful metric for comparing leveraged investments.
Capitalization Rate (cap rate) is a property's annual NOI divided by its purchase price (or current market value), expressed as a percentage. It's an unlevered yield metric — the return an all-cash buyer would earn before financing.
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