"Useful life" is an accounting term that refers to the period of time a capital asset can be expected to be usable by a business.
The concept of useful life is necessary for tax purposes. While smaller items purchased for maintenance and everyday business use can be counted as business expenses all at once, capital assets (generally considered to be anything with a useful life greater than one year) are counted as expenses a little bit at a time. This process is known as depreciation, and each year's deduction is known as a depreciation expense or depreciation charge.
As a basic example, let's say that you spend $1,000 on an asset with a useful life of five years. Instead of deducting the $1,000 right away, you would deduct, or depreciate, $200 every year for five years. This is called straight-line depreciation, and there are some more complex methods of depreciation businesses can elect to use, but this is the basic idea.
Instead of coming up with a unique useful life estimate for every asset, the IRS has broad guidelines based on average life of certain types of assets for business owners to use. Just to name a few examples of common business assets: Computers, office equipment, and vehicles have five-year useful life spans, according to IRS guidelines. Appliances and office furniture are examples of assets with seven-year useful lives.
Useful life of real estate assets
Real estate is a somewhat unique case. Most capital assets you can depreciate will get "used up" eventually. For example, if I buy a new laptop to use for my business, it's reasonable to expect the laptop to be obsolete and in need of replacement a few years down the road.
On the other hand, real estate is ever "used up," nor does it typically lose value over time -- quite the opposite, actually. Over time, real estate assets have historically increased in value approximately in line with inflation. Even so, real estate is a depreciable capital asset for tax purposes.
The issue is that there's a broad "useful life" for real estate in the real world. I've seen poorly constructed homes ready to be torn down within 15 years of service as a rental property, and there are some homes that have been around since the 1700s that are still habitable. It all depends on the property.
To level the playing field for all real estate investors, the IRS sets standard useful life guidelines. For residential properties, the useful life is considered to be 27.5 years, while commercial properties get a longer 39-year lifespan. So, you would deduct an annual depreciation expense on your taxes each year until the asset's useful life expires.
Finally, it's important to mention that only buildings are depreciated, not land. Land isn't considered a capital asset because raw land doesn't need maintenance and can't deteriorate in condition over time. So, if you own a rental property, you'll need to back the value of the land out of the calculation before computing any depreciation.
Why useful life is important to real estate investors
Useful life is an extremely important concept for real estate investors to know because it's used to determine the annual depreciation of a property, which is deducted from the property's taxable income.
As an example, let's say that you purchased a residential rental property five years ago and your cost basis (minus the value of the land) is $200,000. Since the useful life of residential real estate for tax purposes is 27.5 years, you would divide the cost basis by the useful life to calculate annual depreciation of $7,273.
Depreciation is one of the biggest advantages real estate investors have, as it can dramatically reduce or even eliminate their taxable income. Continuing our example, if the property had net rental income of $10,000 for the year after all expenses, the depreciation deduction would reduce this to just $2,727.
To be sure, there's quite a bit more to know about depreciation, such as what happens to your cost basis when you make improvements to the property and how accumulated depreciation affects your taxes when you sell. If you'd like to learn more, here's a more thorough guide to depreciation for real estate investors.
The Millionacres bottom line
You may have heard that one of the reasons real estate can be such a great investment is because of its tax benefits. Depreciation is one of the biggest tax advantages of real estate investing, and you'll need to understand the concept of useful life to accurately determine your depreciation each year, which can save you thousands of dollars on your taxes.