Is Depreciation an Operating Expense?

Not for a rental property. Depreciation is left out of net operating income because it is a non-cash tax deduction, not a cost of running the building. It shows up on your tax return, on Schedule E, and never on the property's operating statement.

Why NOI leaves depreciation out

Net operating income measures the cash a property produces before financing and before the owner's tax return. Depreciation fails on both counts. No check is written for it, and its size depends on the owner's purchase price and tax choices, not on how the building runs.

Two investors who own identical buildings will report different depreciation if one bought in 2012 and the other last year. Their NOI is the same. Keeping depreciation out is what lets a buyer, an appraiser and a lender compare the property rather than the owner. The NOI formula stops at operating expenses for that reason.

Depreciation on a $500,000 rental

Say $100,000 of the price is land, which never depreciates. The IRS lets you recover the remaining $400,000 of residential building over 27.5 years, so the annual deduction is about $14,545. Commercial buildings use 39 years.

None of that touches the operating statement. The house still produces $28,892 of NOI from $45,600 of collected rent and $16,708 of operating expenses. The $14,545 shows up later, on Schedule E, where it can turn a cash profit into a tax loss.

Line	Operating statement (NOI)	Tax return (Schedule E)
Collected rent	$45,600	$45,600
Operating expenses	$16,708	$16,708
Mortgage interest	Not included	Deducted
Depreciation	Not included	$14,545
Result	NOI $28,892	Taxable income, after interest

Where depreciation does matter to an investor

Depreciation is one of the biggest reasons rentals are taxed lightly. It shelters cash flow from income tax while you own the property, and a cost segregation study can pull more of it into the early years.

It comes back when you sell. The IRS taxes the depreciation you took, or could have taken, as depreciation recapture at up to 25%. So it changes your after-tax return, but never the NOI or the value a cap rate puts on the building.

Run the numbers on your property

The calculator below is loaded with the $500,000 example. Change any line to see how depreciation moves NOI and value, or read the full operating expense checklist for every line that belongs above NOI.

Itemized income and expense lines

Income

Monthly rent (all units)$Scheduled rent at full occupancyUnitsFor per-unit figures. 1 for a house or condo.Other monthly income$Parking, laundry, pet rent, storage, utility billbackVacancy and credit loss%$2,400 a year. 5 to 8% is typical.

Operating expenses

Annual property taxes$Use the bill after reassessment, not the seller'sAnnual insurance$Landlord policy, plus flood or wind where neededHOA dues (monthly)$Owner-paid utilities (monthly)$Water, sewer, trash, gas, common-area electricOther monthly expenses$Lawn, snow, pest, licenses, legal, accounting

Price and market (optional)

Purchase price or value$Leave at 0 if you only need NOI. Turns on the cap rate.Market cap rate%What comparable properties sell at. Values the NOI.

Net operating income (annual)

$28,892

$2,408 a month

Typical expenses · 37% ratio

Typical. 30 to 45% of collected income covers expenses, the range most single-family and small multifamily rentals land in with every cost counted.

Income statement

Gross scheduled income: $48,000
Vacancy and credit loss: -$2,400
Effective gross income: $45,600
Property taxes: -$6,000
Insurance: -$2,500
Maintenance: -$2,280
Capital reserves: -$2,280
Management: -$3,648
Total operating expenses: -$16,708
Net operating income: $28,892
Expense ratiooperating expenses / effective gross income: 36.6%
NOI marginNOI / effective gross income: 63.4%

What this NOI is worth

Value at a 6.50% cap rate: $444,492
Cap rate at this price$28,892 / $500,000: 5.78%
Priced above that value by: $55,508
Gross rent multiplierprice / gross scheduled income: 10.4

What moves it

Each $100/mo of rent addsof annual NOI after vacancy and percentage expenses: $935
Each point of vacancy costsof annual NOI: $394
Each $1,000 of NOI is worthat a 6.50% cap rate: $15,385

Depreciation and NOI questions

Is depreciation an operating expense or a non-operating expense?

On a rental property it is neither. Depreciation is excluded from the operating statement and from NOI entirely, and only appears on the tax return as a non-cash deduction against rental income.

Does NOI include depreciation?

No. NOI is collected income minus operating expenses, and depreciation is not an operating expense on a property statement. Adding it would make NOI depend on the owner's purchase price and tax position, which defeats the point of the measure.

Sources: IRS Publication 527, Residential Rental Property · IRS Publication 946, How To Depreciate Property