Depreciation is a tax-deduction tool that allows commercial real estate owners to offset the cost of their property over time. It reflects the natural wear and tear that a building experiences, reducing taxable income while helping owners maximize the value of their investment. For commercial properties, depreciation is typically calculated over a 39-year period, making it an essential component in real estate investment strategy.
How Does Depreciation Work?
When an investor purchases a commercial property, the IRS allows the cost of the building (but not the land) to be written off over 39 years. This write-off is based on the assumption that the property will gradually lose value due to usage, age, and physical deterioration. Each year, the investor can claim a portion of the building’s cost as a depreciation expense, reducing taxable income and improving cash flow.
Calculating Depreciation
To calculate depreciation, the investor must determine:
- Building Value: Only the building’s value (not the land) can be depreciated. Investors often rely on property appraisals or tax assessments to separate land and building values.
- Depreciation Method: Commercial real estate uses the straight-line method, which spreads depreciation evenly over 39 years. For example, if a building is valued at $1,000,000, the annual depreciation expense would be roughly $25,641.
Key Benefits of Depreciation in Commercial Real Estate
- Tax Savings: Depreciation allows investors to lower taxable income each year. For high-income investors, this can be a significant tax advantage, reducing overall tax liability and freeing up capital for reinvestment.
- Enhanced Cash Flow: By reducing taxable income, depreciation helps investors retain more cash flow, which can be reinvested into property improvements or new acquisitions.
- Offsetting Income: Depreciation deductions can offset rental income, helping minimize the tax burden and increase net profitability for the property.
What Happens When You Sell?
When selling a commercial property, investors need to recapture depreciation. Depreciation recapture is a tax that applies to the accumulated depreciation taken over the holding period and is typically taxed at a higher rate of 25%. While depreciation recapture increases the tax liability at sale, the benefits of depreciation over time usually outweigh this eventual cost, as it provides ongoing tax savings throughout ownership.
Accelerated Depreciation Options
Investors may also consider accelerated depreciation methods, like cost segregation studies, to further maximize tax benefits. Cost segregation allows for a breakdown of the building into shorter-lived components (e.g., carpeting, fixtures) that can be depreciated over 5, 7, or 15 years, providing more substantial deductions in the early years of ownership. This strategy is particularly advantageous for high-income investors or those planning to hold the property for a limited time.
Important Considerations for Investors
- Property Condition: Only properties used for business or income generation are eligible for depreciation. Personal-use properties are not eligible.
- Improvement Costs: Significant improvements, such as major renovations or roof replacements, can be depreciated separately over a shorter timeline, providing added tax benefits.
- Impact of Sale or Exchange: Depreciation deductions lower the property’s adjusted basis, potentially increasing capital gains taxes at sale. However, strategies like a 1031 Exchange can help defer tax liabilities.
Conclusion
Depreciation is a vital tool in commercial real estate investment, providing tax advantages that improve cash flow and support portfolio growth. By understanding depreciation’s impact, investors can strategically manage their tax burden and reinvest more capital into future opportunities.
