Although the word ‘depreciation’ sounds like a loss, it’s actually a big gain for commercial real estate investors and a key reason why people invest in real estate. Here’s a quick look at how commercial real estate depreciation works.
What is commercial real estate depreciation?
The Internal Revenue Service (IRS) allows commercial real estate investors to reduce the value of their investment property in equal installments over a period of 39 years. This ‘useful life’ of the property doesn’t include the land value, only the building and improvements.
Many real estate investors consider depreciation to be just as important as the cash income and potential increase in market value that a property generates.
Benefits of commercial real estate depreciation
Commercial real estate depreciation acts as a ‘tax shelter’ by reducing the taxable income of investors. Here’s a quick example of how real estate depreciation for commercial property works using the straight-line depreciation method:
- Value of building only = $1 million
- Annual depreciation deduction = $1 million / 39 years = $25,641
- Investor taxable income = $225,000 – $25,641 depreciation expense = $199,359
In this case, the investor’s income tax liability is structured as follows:
Note that the depreciation expense deduction is per property, not per investor. So, it’s quite possible that active commercial real estate investors could have a total depreciation expense deduction that reduces their taxable income to $0.
What kind of property can be depreciated?
Property that falls into one or more of these categories can be depreciated:
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- 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)
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Depreciation methods for commercial real estate
Most commercial real estate is classified as ‘Section 1250’ property by the IRS and falls under the MACRS or modified accelerated cost recover system. The two sub-systems of MACRS are GDS (general depreciation system) and ADS (alternate depreciation system).
IRS asset classes under the GDS and ADS systems are assigned varying estimates of asset life. However, commercial real estate must use the straight line method of depreciation over 39 years.
IRS Publication 544 (2018) discusses the depreciation and sale of assets in-depth.
Formula for depreciating commercial real estate
The formula for depreciating commercial real estate looks like this:
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- Cost of property – Land value = Basis
- Basis / 39 years = Annual allowable depreciation expense
- $1,250,000 cost of property – $250,000 land value = $1 million basis
- $1 million basis / 39 years = $25,641 annual allowable depreciation expense
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The IRS allows to begin depreciating property when it is put into service and starts generating income, not when the property is bought. Also, a property can’t be depreciated if put into service and removed from service the same calendar year.
Annual depreciation continues until one of two things takes place:
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- The entire basis of the property has been deducted (or depreciated)
- The property is sold or removed from service as an income-producing property
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Depreciation recapture and 1031 exchanges
What the IRS gives, the IRS will eventually take back in the form of depreciation recapture. When commercial real estate is sold, the difference between the basis and the sales price must be reported as income in the year the sale is made.
However, the IRS also allows investors to use a 1031 tax deferred exchange when selling one investment property and buying another. By deferring the payment of capital gains tax, investors can roll this additional cash into buying a larger property or by diversifying their property portfolio.
FAQs about commercial real estate depreciation
Questions and answers to some of the most frequently asked questions about commercial real estate depreciation include:
Q: How does a property become ‘fully depreciated’?
A: For the tax purposes of depreciation deduction, a commercial property is ‘fully depreciated’ after 39 years.
Q: What is a ‘depreciation schedule’?
A: A depreciation schedule keeps track of the depreciation for each asset. A typical depreciation schedule includes a property description, cost, estimated life, method of depreciation, date purchased, current and accumulated depreciation, and net book value.
Q: Is it just real estate that can be depreciated?
A: No, capital expenditure improvements (CAPEX) can be depreciated in addition to the building itself, although these items can be depreciated over a schedule of just a few years. CAPEX includes appliances, furnaces, windows and roof replacement, TIs, equipment used to maintain the property, and landscaping improvements.
Key takeaways for commercial real estate depreciation
Commercial real estate depreciation lets investors expense the cost of income producing property over time, lower the amount of personal income tax paid, and even roll over and defer the payment of capital gains tax when property is sold.
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- Depreciation deduction for commercial property can create tens of thousands of dollars in tax savings each year
- Commercial depreciation allows investors to reduce or even completely eliminate their taxable income each year
- Commercial real estate depreciation is a legal ‘tax shelter’ used by savvy investors
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