Depreciation deductions are based on the idea that things (even houses) wear out over time. While this happens at varying rates depending on what it is we’re talking about the assumption stands for pretty much anything we purchase. For instance, if we purchase a new refrigerator for $1,000 we do not have an expense for $1,000 because we simply traded $1,000 in cash for a $1,000 appliance. We still have $1,000 in value (in the form of a refrigerator). As time goes on, however, the refrigerator wears out and declines in value. This loss in value is our depreciation expense.
Using our $1,000 refrigerator as an example let’s assume that one year from now it’s worth $800. Since we paid $1,000 for it and the thing we bought (the appliance) is now only worth $800 we’ve generated an expense of $200 by using the fridge. This $200 is our depreciation expense, or more accurately, our depreciation deduction.
In order to make these deductions uniform the IRS has some rules to simplify depreciation. Appliances, carpets that are not glued down, window coverings, etc. are all five year items and are depreciated over five years. Things like driveways and landscaping are 15 year items and so forth.
It should be noted that the rental property itself, not just the items in it, depreciates. Generally we think of houses as going up in value over the long term, not down. To the IRS, however, a house lasts 27.5 years from the time you buy it regardless of whether the house is brand new when purchased or already 50 years old. In addition rental properties MUST be depreciated over this 27.5 year period. It is not an option (see rental property depreciation examples).
If you own a rental property be sure to understand how depreciation recapture works as well.