Although the term ‘depreciation’ implies a loss, it is a significant benefit for commercial real estate investors and an important reason why individuals buy real estate. Here’s a basic rundown of how depreciation in commercial real estate works.
Real estate depreciation
According to the current U.S. Tax Code, business and residential building assets can be depreciated over a 39-year straight line for commercial property and a 27.5-year straight line for residential property. Under the Modified Accelerated Cost Recovery System, the Internal Revenue Service (IRS) permits building owners to depreciate specific land improvements and personal property over a shorter period than 39 or 27.5 years. For example, certain land improvements can be depreciated at 150 percent DB over 15 years, whereas private property can be discounted at 200 percent DB over 7 or 5 years. A cost segregation study is a form of depreciation analysis.
Benefits of commercial real estate depreciation
Depreciation in commercial real estate functions as a ‘tax shelter,’ lowering investors’ taxable income. Here’s an example of how the commercial property straight-line depreciation technique works:
The structure is only worth about $1 million.
$1 million divided by 39 years equals a depreciation deduction of $25,641 each year.
$199,359 in taxable revenue minus $25,641 in depreciation expense
Due to commercial real estate depreciation, not only has the investor’s taxable income fallen, but the tax rate has also changed from 32 percent to 24 percent.The investor’s income tax liability has decreased from $72,000 to $47,846 ($225,000 income x 32%).
It’s important to note that the depreciation expense deduction applies to each property, not each investment.
As a result, active commercial real estate investors may be able to claim a total depreciation expense deduction that lowers their taxable income to zero.
What type of property can be depreciated
Depreciation can be applied to property that fits into one or more of these categories:
- Rental property was placed into service after 1986.
- Multifamily property including duplex or triplex, as well as residential income property, such as a duplex or triplex (depreciated over 27.5 years)
- Commercial real estate that creates revenue that is owned by the owner of commercial real estate that generates revenue (39 years)
The IRS classifies most commercial real estate as ‘Section 1250’ property, subject to the MACRS or modified accelerated cost recovery scheme. GDS (general depreciation system) and ADS (adjustment depreciation system) are the two subsystems of MACRS (alternative depreciation system).
Under the GDS and ADS systems, IRS asset types are assigned variable asset life predictions. On the other hand, commercial real estate must depreciate in a straight line over 39 years.
Depreciation and asset sales are covered in depth in IRS Publication 544 (2018).
How to use real estate depreciation
Here’s an illustration of how depreciation in commercial real estate works:
The costs of installing a 3/4-inch copper pipe connecting to a toilet sink in a supermarket building must be amortized over 39 years. A bakery sink with the same 3/4′′ pipe qualifies for a 5-year write-off. The bakery sink is tied to the taxpayers’ business, whereas the restroom sink is related to the building’s function. Over time, all buildings, whether commercial or residential, will require repairs. Anyone who has owned a commercial or residential rental property for a long time understands that it will require upkeep, repairs, and renovations. The Tangible Property Regulations (TPR) are a new tax law that allows building owners to sell assets when they are replaced.
1031 exchanges and depreciation recapture
The IRS will eventually take back what it grants in the form of depreciation recapture. The distinction between the basis and the sales price must be declared as income in the year the property is sold.
However, when selling one investment property and buying another, the IRS allows investors to execute a 1031 tax deferred exchange. As a result, investors might use the extra cash they save by delaying capital gains tax to buy a larger home or diversify their property portfolio.
Accounting of depreciated buildings
Your accounting must track the carrying amount of fixed assets, such as buildings, equipment, and vehicles, per Generally Accepted Accounting Principles (GAAP). According to AccountingTools, the carrying value equals the purchase price less accrued depreciation and impairment losses. Therefore, regardless of the current market value, you determine the carrying amount of the building using depreciation. You can also keep track of the depreciation that has accrued over time.
Assume your landscaping company spends $250,000 on a storage building for your equipment as an example of accumulated depreciation. Depreciation is calculated based on the usable life of the building and its salvage value at the end of that life. According to Salt Lake Community College, a new structure depreciates over 40 years. If you expect it to have no salvage value, you depreciate it at the same rate each year till the value is 0, which works out to $6,250 every year.
Commercial real estate depreciation allows investors to depreciate the cost of the income-producing property over time, reduce personal income tax, and even roll over and defer capital gains tax payments when the property is sold. It is also a legal ‘tax shelter’ used by investors.