One of the most valuable tax deductions available to real estate investors is depreciation. This is the process of deducting the cost of buying investment real estate over a period of time. However, like most tax topics, there’s more to the story.
With that in mind, here’s a rundown of:
- what depreciation is,
- how it applies to commercial real estate,
- how it can reduce your taxes each year, and
- the tax implications of depreciation when you sell.
What is depreciation?
When you spend money for business purposes, the cost can generally be “written off” or deducted from the business’ profits for tax purposes.
There are two main ways to deduct business expenses. Some expenses are deducted all at once in the year they were incurred. These include:
- money spent for an item that is immediately consumed,
- day-to-day costs of doing business, and
- small-dollar purchases.
For example, if your business spends $500 on office supplies in 2019, you can deduct this expense when you file your 2019 tax return.
On the other hand, you deduct expensive assets that last for several years over time. For example, if you spend $1,000 on a piece of office furniture you expect to last five years, you might deduct $200 per year for the next five years. This is a simplified explanation, and there are several other potential ways to deduct certain assets over time. But this is the general idea behind depreciation.
As we’ll see over the next few sections, real estate held for commercial purposes is a depreciable business asset. This can be a major tax benefit for real estate investors, especially when it comes to high-cost commercial properties.
How are commercial properties depreciated?
To make deductions easier, the IRS gives guidelines on the useful life of many assets for depreciation purposes. There’s no way to know exactly when an asset will be “used up,” and different assets in the same category can have different useful lifespans. For example, a cheap low-quality printer might last for a year, while a heavy-duty industrial one could last a decade or more.
The same concept applies to real estate. There are poorly constructed buildings that need to be torn down after 10 years, and there are commercial buildings that have been in service for hundreds of years.
To create a universally applicable process, the IRS has set depreciation periods for real estate. For residential properties, the depreciation period is 27.5 years. For commercial real estate, it's 39 years.
It’s also worth mentioning that you can’t depreciate land. The land a building is on doesn’t get “used up” over time. Only the building is depreciable. There are a few acceptable ways to determine the value of the land, including a property appraisal or tax assessment.
As a simplified example, let’s say you purchase an office property for $1 million and that the appraised value of the land is $200,000. This gives you a building value of $800,000. Dividing this amount by 39 gives you a $20,513 depreciation expense for every full year you own the property. During the first year of ownership, the IRS provides guidelines on how to prorate the deduction.
You can continue to take depreciation deductions on your commercial properties each year until you sell or until your entire cost basis in the property has been depreciated.
What is your cost basis?
Here’s where it gets more complicated. Your cost basis in the property isn’t necessarily the price you paid the seller when buying the property. There are a few other things that can add to your cost basis.