AN OVERVIEW OF WHAT DEPRECIATION IS IN COMMERCIAL REAL ESTATE INVESTING

What is Commercial Real Estate Depreciation?

The term “depreciation” is used to describe the decline of an asset’s value over time. For example, cars depreciate the minute you drive one off the lot, and manufacturing equipment and computers all eventually wear out or depreciate. According to the IRS Publication 527, commercial real estate depreciates over a period of 39 years while residential property including apartments and multifamily buildings depreciates over 27.5 years. After that time, the property is completely worn out, at least for tax purposes.

Although depreciation normally describes a loss in value, depreciation in real estate is actually just as big a benefit as passive income, if not more so. That is because tax laws in the U.S. allow real estate investors to take an annual deduction for the depreciation that reduces the amount of taxes paid on the net income the property generates. Commercial property depreciation is the aging of commercial real estate assets and fixtures over time. The decrease in value of things like Plant and Equipment and even the building itself can be used to reduce your taxable income. Depreciation is effectively a value-add for commercial property investors.

Depreciation is used by real estate investors, including triple-net (NNN) lease investors, to recover the cost of a commercial income property and increase net operating income (NOI). Depreciation assumes there is a loss in value due to the physical deterioration of the property, which creates significant tax opportunities for the owner.

 

Examples of Commercial Buildings

Examples of commercial buildings include industrial, warehouses, manufacturing, offices, shopping centers, supermarkets, retail, restaurants, hotels, motels, casinos, entertainment, auto dealerships, self-storage, hospitality, hospitals, MOBs, etc. Apartments and rental homes are considered residential property that qualifies for a shorter building depreciation life than commercial buildings.

 

What kind of property can be depreciated?

Property that falls into one or more of these categories can be depreciated:

• Rental property placed into service after 1986
• Residential real estate used to produce income and multifamily property such as a duplex or triplex (depreciated over 27.5 years)
• Owner-occupied commercial real estate or income-producing commercial real estate (39 years)

 

How is Depreciation Calculated?

While the land your NNN lease building sits on doesn’t depreciate, there are numerous assets of the property that are eligible. Over the course of a year, by taking depreciation, you can reduce taxable income by thousands of dollars.

Therefore, it is critical to make sure you claim the correct type and amount of depreciation each year to maximize your internal rate of return (IRR).

 

Straight Line Depreciation

The IRS has several specific formulas that need to be followed when applying depreciation expenses to your investment properties but the simplest and most common method that applies to most properties is called straight-line depreciation.

As the name suggests, straight-line depreciation requires that you spread out the original cost of the property evenly, over a set period of time. Straight-line depreciation is the most straightforward way to estimate the loss of value of your NNN property over time. To get your depreciation figure, which in this type of depreciation is a fixed number, divide the difference between the property’s cost and its expected salvage value by the number of years it is expected to be used.

 

The Straight-Line Depreciation Formula

You need to know three numbers to calculate the straight-line depreciation:

• The Acquisition Cost
• The Salvage Value (or Land Value)
• The Useful Life or Depreciation Period

 

1. Acquisition Cost

This is normally the purchase price, plus related acquisition costs like sales taxes, shipping, or installation fees. In the case of real estate, some closing costs are depreciable, but not all. 

 

2. Salvage Value

When the item reaches the end of its useful life, it usually still has some scrap value. In real estate, even when a building collapses, burns down, or otherwise offers no more value, the land value remains, so the land value serves as the salvage value.

 

3. Useful Life

The IRS specifies a depreciation lifespan for various business and investment expenses. This ‘useful life’ of the property doesn’t include the land value, only the building, and improvements. To make the calculation, you subtract the salvage value (i.e. – land value) from the acquisition cost, and then divide that number over the years of useful life (27.5 years for residential, 39 years for nonresidential). 

 

Example of Straight-Line Depreciation

Imagine you buy a rental property for $150,000. The assessor puts the land value at $50,000, and the improvement (the building) value at $100,000. So, you divide the $100,000 building value by 27.5 years, for an annual depreciation of $3,636.36. That’s how much you can deduct each year for the next 27.5 years for depreciation, for that particular property.

 

Cost Segregation Depreciation

Cost segregation depreciation may allow nonstructural improvements such as indoor and outdoor lighting, heating and cooling systems, and parking lot and landscaping, to be depreciated over five, seven, or 15 years, versus 39 years.

This substantially shorter depreciable tax life helps you preserve capital, realize immediate cash flow, and achieve significant tax relief on new and existing buildings. These benefits are also gained through asset reclassification and write-offs when the asset is sold. In summary, CSD allows you to:

• Adjust the timing of deductions to maximize tax savings.
• Swiftly depreciate expenses.
• Reduce/defer current tax liability.
• Increase cash flow for other investment opportunities or operating expenses.
• Take 100% of the adjustment (on buildings purchased after September 2017) in one year, i.e., bonus depreciation.
• Reclaim deductions dating back to 1987 without having to amend tax returns.
• Create an audit/paperwork trail that satisfies the IRS’s audit techniques guide.

 

The only way to determine if your NNN property qualifies for the maximum Cost Segregation benefit is to have engineering, architecture, construction, or tax accounting specialists perform a cost segregation study. A Cost segregation study is performed when buying a new building, but it can also be performed on a building owned for many years. New deductions can be taken back to 1987 without amending tax returns.

 

How to Calculate Real Estate Depreciation in 3 Simple Steps

Real estate depreciation calculation is not difficult to understand. Here’s how you would calculate it in 3 simple steps:

• Real estate value is made of land and building values, but depreciation only applies to the building. The first step is the price should be allocated between land and building value.
• Since land is not subject to depreciation, the building would be depreciated over the IRS-prescribed useful life. This life is designated as 27.5 years for residential rental property and 39 years for commercial property. Divide your building value by 27.5 to get your depreciation expense.

• Multiply the depreciation expense by your marginal tax rate to get your property tax savings from real estate depreciation.

 

The formula for depreciating commercial real estate

The formula for depreciating commercial real estate looks like this:

 

-Cost of property – Land value = Basis

-Basis / 39 years = Annual allowable depreciation expense

 

-Example:  $1,250,000 cost of property – $250,000 land value = $1 million basis

-$1 million basis / 39 years = $25,641 annual allowable depreciation expense

 

 

What Are the Tax Benefits of Depreciation?

Depreciation is a method used to allocate the cost of tangible assets or fixed assets over an asset’s useful life. In other words, it allocates a portion of that cost to periods in which the tangible assets helped generate revenues or sales. By charting the decrease in the value of an asset or assets, depreciation reduces the amount of taxes a company or business pays via tax deductions.

A company’s depreciation expense reduces the number of earnings on which taxes are based, thus reducing the amount of taxes owed. The larger the depreciation expense, the lower the taxable income, and the lower a company’s tax bill. The smaller the depreciation expense, the higher the taxable income and the higher the tax payments owed.

 

Here’s an example of why depreciation is such a major tax benefit for real estate investors:

If you buy a self-storage property for $1,500,000 (acquisition costs included), the assessment indicates that the land value is $500,000. Now you have a depreciable cost basis of $1,000,000, and let’s say that the property brings you $150,000 in rental income over your first full year of ownership. You will have the following deductible expenses:

• Rental revenue – $150,000
• Property taxes  – $15,000
• Management expenses – $50,000
• Insurance – $5,000
• Marketing costs – $5,000
• Other expenses – $10,000
• Income after expenses – $65,000
• White spacious stairs in an office building

 

What Is Depreciation Recapture?

Depreciation recapture is the gain realized by the sale of depreciable capital property that must be reported as ordinary income for tax purposes. Depreciation recapture is assessed when the sale price of an asset exceeds the tax basis or adjusted cost basis. The difference between these figures is thus “recaptured” by reporting it as ordinary income.

Depreciation recapture involves paying taxes on gains you had previously deducted for in the form of depreciation. You pay taxes on gains over your adjusted cost basis. Depreciation recapture is a tax provision that allows the IRS to collect taxes on any profitable sale of an asset that the taxpayer had used to previously offset their taxable income. Since depreciation of an asset can be used to deduct ordinary income, any gain from the disposal of the asset must be reported and taxed as ordinary income, rather than the more favorable capital gains tax rate.

 

CONCLUSION

Depreciation in real estate along with recurring cash flow and potential appreciation in property value over the long term is one of the biggest benefits of investing in income-producing real estate. Depreciation is a non-cash expense used to reduce taxable net income from investment real estate. Thanks to depreciation, investors pay less in taxes while keeping more cash as profit to reinvest.

Knowing which type of depreciation will give you the most favorable Internal Rate of Return is important when you own a commercial property and when you purchase an investment property. When buying in a 1031 exchange, the tax opportunities of the exchange plus the depreciation recapture, along with a Cost Segregation on a new or existing building, will provide a clearer picture of your capital preservation and return over the life of the investment.

 

As informed investors we should understand the risks associated with real estate investing and that there is no guarantee. Please do your due diligence.