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.
For example, any costs involved with acquiring the property add to your cost basis. Legal fees or recording fees paid to your local government can be added to your cost basis, for example.
You can add any substantial improvements to the property that are permanent or add value, as well. Examples include building an addition on a property, adding a swimming pool to an apartment building, and renovating the bathrooms in a commercial property.
A real estate depreciation example
Here’s an example of how this works and why depreciation is such a major tax benefit for real estate investors.
Let’s say you purchase a self-storage property for $1,500,000, including acquisition costs. A recent assessment indicates that the land value is $500,000, so you have a depreciable cost basis of $1,000,000. We’ll say that the property brings in $150,000 in rental income over your first full calendar year of ownership. You also had the following deductible expenses:
|Income after expenses||$65,000|
In addition to these deductions, the property would be entitled to an annual depreciation expense of $25,641 ($1 million divided by 39). So while the property’s income after accounting for expenses is $65,000, the depreciation deduction reduces the property’s taxable income to just $39,359.
When you sell a commercial property
As we just saw, the depreciation deduction can make a big dent in your tax bill. The caveat is that when a commercial property is sold, the IRS essentially takes that tax benefit back through a tax known as depreciation recapture.
Here’s the short version of how this works. Let’s say you purchase a commercial property for $1.5 million as in our previous example. Now let’s say you sell the property five years later for $1.7 million.
In this case, the $200,000 difference would be taxable as a capital gain. Additionally, the $128,205 in depreciation deductions you would have received over the five-year ownership period would also be considered taxable income thanks to depreciation recapture.
Commercial property owners can defer paying taxes on the sale of property by completing a 1031 exchange, which essentially means using the sale proceeds to acquire another property. There are several rules to know when completing a 1031 exchange regarding the acquired property and the timetable involved. Be sure to do your homework (or seek qualified advice) before starting the process.
The key takeaways
To sum up the key points on commercial property depreciation:
- Depreciation lets you deduct the cost of acquiring an asset (in this case, real estate) over a period of time. The depreciation period is 27.5 years for residential properties and 39 years for properties of a commercial nature.
- This reduces a commercial property’s taxable income each year and can even make a profitable commercial property show no taxable income at all.
- When a property is sold, depreciation deductions claimed throughout the ownership period are considered taxable income. This is known as depreciation recapture.
- However, all taxes on the sale of a commercial property can be avoided if the sale proceeds are reinvested in another property, which is known as a 1031 exchange.
Real estate depreciation is a complicated topic. But it pays to do your research, because you could use it to save yourself hundreds or thousands of dollars in taxes every year.