Commercial real estate depreciation is a complex and often misunderstood topic. There are a number of different methods that can be used to calculate depreciation, and the choice of method can have a significant impact on the value of a property.
In addition, the tax treatment of commercial real estate depreciation can vary depending on the type of property and the country in which it is located. As a result, it is important to seek professional advice when considering depreciating a commercial real estate investment.
This blog will provide an overview of the different types of depreciation and the tax implications of each. It is our hope that this information will help readers to make informed decisions about their investments.
What is commercial real estate depreciation?
Commercial real estate depreciation is an important but often misunderstood tax deduction. Basically, it allows owners of an income-producing property to recover the cost of their investment over time through annual deductions on their taxes. This deduction is based on the useful life of the property, which is determined by the IRS.
For example, an office building has a useful life of 39 years, so its owner can deduct 3.85% of its purchase price each year as depreciation. This deduction can have a significant impact on an investor’s cash flow, and it’s one of the main reasons why commercial real estate can be such an attractive investment.
Depreciation Strategies for Businesses and Tax Considerations
Businesses can use depreciation to recover the cost of certain business assets over time. The types of assets that are eligible for depreciation include machinery, equipment, vehicles, furniture, and buildings.
The IRS allows businesses to use either the straight-line method or the declining balance method to calculate depreciation. The choice of method can have a significant impact on the amount of depreciation that a business can claim each year.
Two Main Methods of Calculating Depreciation
Let’s review the two most common methods that are used in the calculation of depreciation: the straight-line method and the declining balance method.
The straight-line method
The straight-line method is the most common method used to depreciate assets. Under this method, depreciation is calculated by dividing the cost of an asset by its useful life.
For example, if a company purchased a piece of equipment for $10,000 and it had a useful life of 10 years, the annual depreciation expense would be $1,000 ((10,000 – 0) / 10). The key assumption under the straight-line method is that the asset will generate equal amounts of revenue over its useful life.
This method is simple to calculate and understand, yet it may not always provide the best estimate of an asset’s true value. As a result, companies should consider all available options before selecting a depreciation method.
The declining balance method
The declining balance method is another way to calculate the depreciation of an asset. With this method, the asset is assumed to lose a larger percentage of its value in the early years and a smaller percentage in later years.
The amount of depreciation is calculated by multiplying the depreciation rate by the ending balance of the asset.
For example, if an asset has a depreciation rate of 20% and an ending balance of $1,000, the amount of depreciation would be $200 ($1,000 x 20%). The declining balance method can be used for both tax and accounting purposes.
Assessing the Cost of Each Component
When it comes to depreciating an asset, there are a few factors that need to be taken into account in order to get an accurate figure. The most obvious cost is the purchase price of the asset, but this is not the only expense that needs to be considered. Any installation or set-up costs associated with the commercial real estate property should also be included in the depreciation calculation.
For example, if a company purchased a property for $100,000 and spent an additional $20,000 to renovate it, the total cost of the asset would be $120,000.
It is important to make sure that all relevant costs are taken into account before depreciating an asset.
Recapture of Depreciation
When an asset is sold, any depreciation that has been taken on the asset must be “recaptured” and included in the taxable gain from the sale. The amount of depreciation recapture is equal to the difference between the sales price of the asset and its tax basis.
The tax basis of an asset is its original cost, plus any capital improvements that have been made, minus any depreciation that has been taken.
For example, if an investor purchased a property for $100,000 and made $20,000 in capital improvements, and took $30,000 in depreciation deductions over the years, the tax basis of the property would be $90,000 ($100,000 + $20,000 – $30,000).
If the property was sold for $200,000, the investor would have a taxable gain of $110,000 ($200,000 – $90,000). Of this amount, $30,000 would be recaptured depreciation and taxed at the investor’s marginal tax rate.
The remaining $80,000 would be considered a long-term capital gain and taxed at a lower rate.
It is important to note that recaptured depreciation is not subject to the special rules that apply to capital gains. This means that it is not eligible for the 15% or 20% preferential tax rates.
As a result, it is important to consider the tax implications of selling an asset before deciding to do so.
As we’ve seen, commercial real estate depreciation can be a complex process. However, understanding the basics of depreciation can help you make informed decisions about your property investments.
When it comes time to file your taxes, be sure to work with a qualified tax professional to ensure that you take advantage of all the deductions and credits you’re entitled to.
As always, if you have any questions about this or any other real estate topic, feel free to reach out to us. We’re here to help!
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