Under Generally Accepted Accounting Principles (GAAP), an expense can be applied to reduce the carrying value of a capital asset, which is usually a long-term asset such as a commercial property. This is done to reflect the decrease in the value of an asset over the course of its useful life as a result of wear and tear. This expense is calculated and added to the amount from the prior accounting period to calculate “accumulated depreciation”.
Investors need to be aware of depreciation expenses and the reduction in taxable income that comes with them. Investors also need to be aware of how accumulated depreciation works and how it can result in a larger tax bill when the asset is sold. In this article we will discuss these topics and help investors understand how to think about accumulated depreciation.
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What is Accumulated Depreciation?
Before we can get into accumulated depreciation, we have to understand what depreciation is and how it works.
Depreciation is an expense that is meant to help asset owners account for wear and tear to the asset through the normal course of use. Property, plant, and equipment, including real estate can all be depreciated because the thinking goes that they get “used up” over time. For example, a rental property that is lived in for many years will surely end up with some dents and dings, even if the property management company does a good job maintaining it. There are two ways that depreciation is typically calculated in commercial real estate.
Straight Line Method
The easiest and fastest way to calculate the amount of depreciation is to use the straight line method. With it, a depreciation basis is calculated by subtracting the salvage value of the asset from the purchase price of the property. This represents that amount that can be depreciated over the property’s useful life. This amount is divided by the estimated number of years in its useful life to arrive at the amount of depreciation expense that is to be taken on an annual basis.
Cost Segregation
Cost segregation is a method of calculating depreciation that segments the components of a property and depreciates them at different rates. For example, furniture, fixtures, carpeting, and window treatments are classified as personal property and can be depreciated over five or seven years. Or, sidewalks, paving, and landscaping are classified as land improvements and depreciated over 15 years. These shorter depreciation periods allow property owners to maximize depreciation deductions and, by extension, the resulting tax benefits.
In order to utilize the cost segregation method, a third party consultant is typically hired to perform a cost segregation study, which is used to justify the property’s accelerated depreciation schedule.
Depreciation Method Example
Straight line depreciation is pretty straightforward, but let’s take a look at an example to make sure it’s clear. Suppose that a property has a value of $10MM and an estimated useful life of 30 years. In this case, the amount of annual depreciation would be $333,333 ($10,000,000 / 30). The amount of accumulated depreciation at the end of year five would be $1,666,665 ($333,333 x 5).
Cost segregation is more complicated. IRS rules dictate that a commercial rental property can be depreciated over either 27.5 or 39 years. But, a cost segregation study can break the property up into its individual components and depreciate them at an accelerated rate. For example, interior fixtures and finishes can be depreciated over five years or land improvements could be depreciated over 15 years.
Again, the specifics of the cost segregation process can be tricky, but the key point is to remember that it allows real estate owners to accelerate depreciation in an effort to reduce overall tax liability in the earlier years of an asset’s useful life. But, it is best performed by an expert, with the input of a CPA or tax professional to ensure it is being completed correctly.
Accumulated Depreciation
Accumulated depreciation is simply the aggregate of all the annual depreciation expenses taken on a particular asset over the course of its life-to-date. For example, if a property owner takes depreciation on a straight line basis of $10,000 per year for ten years, then the accumulated depreciation amount that shows up on the company’s balance sheet after ten years will be $100,000. While the annual depreciation figures calculated using the cost segregation method will differ from year to year, the concept used to arrive at the amount of accumulated depreciation is the same.
One thing to note about depreciation is that it is only applied to tangible assets, such as commercial real estate. It is not applied to intangible assets such as copyrights. Instead, the carrying value of intangible assets that is shown on financial statements is reduced according to an amortization schedule. While this is outside the scope of our discussion on accumulated depreciation, it is important to know that the difference exists.
How it Applies to Real Estate Investing
A lot is written about the tax benefits of owning commercial real estate, and this is largely due to the ability of the investor to use depreciation expense to reduce taxable income. There is no doubt that many investors have benefited from this and have been able to grow their net worth through the cash flow and tax deductions available by investing in commercial real estate.
That said, there is a potential downside to depreciation, and that comes when the investor sells a property that has been depreciated for a number of years. As the years go by and depreciation is allocated to a property, the amount of accumulated depreciation will increase as well. As the accumulated depreciation increases, the net book value of the property declines. From a tax perspective, this means that the investor’s cost basis in the asset decreases as depreciation is applied to the property.
The gain on the sale of a property is calculated as the sale price less the asset’s cost basis. So, when depreciation has decreased the cost basis, it opens the investor up to having to pay capital gains tax upon the sale of the property. Investors need to monitor their financial statements and understand what their tax liability will be if they choose to sell a property that has been depreciated.
Is Accumulated Depreciation an Asset or Liability?
For financial reporting purposes, accumulated depreciation is neither an asset or a liability, but rather, it is classified as a contra asset account. This means that its purpose is to reduce an asset’s value on the balance sheet to reflect the total amount of wear and tear on that asset to date.
While depreciation is an expense from an accounting perspective, many investors like to think about it as an asset in the sense that it helps to reduce their taxable income at the end of the year. This is especially true when utilizing cost segregation as part of a tax strategy because it front loads depreciation in the first years of ownership, thereby significantly reducing investor tax liability.
Like we mentioned, accumulated depreciation is neither an asset or liability from an accounting perspective, but many investors view it as a liability of sorts because it reduces their cost basis in the property and results in a higher potential tax bill at the time of sale.
Why Investors Need to Understand Accumulated Depreciation
The most important reason why real estate investors need to understand accumulated depreciation is because it can have a big impact on the cost basis of the property when the investor chooses to sell. Real estate is a great asset class to invest in because depreciation can help to minimize taxable income, but it is important for real estate investors to remember that this same depreciation can be “recaptured” upon the sale of the property, resulting in an unexpectedly large tax bill.
How Accumulated Depreciation Plays into CRE Investing
One of the major benefits of a commercial property investment is the tax benefits that come with it and one of the most notable tax benefits is the use of an accounting concept known as “depreciation.”
Depreciation is a non-cash expense on a property’s income statement that represents the estimated cost associated with the physical deterioration of a property’s condition. Because depreciation helps to reduce an investor’s tax liability, property owners are incentivized to maximize it to the extent allowable by tax law.
For investors who are looking to sell one or more properties, accumulated depreciation can become a major factor that needs to be addressed with an accountant or tax attorney prior to completing the sale. Fortunately, with some simple tax planning, this tax bill can be deferred using another strategy known as a 1031 Exchange. Investors who pursue a 1031 Exchange must comply with a number of rules in order to defer taxes on the sale of a property, so it is important to understand all aspects when planning to sell a property.
Summary of Appreciated Depreciation as an Asset or Liability
Accumulated depreciation is the aggregate of all the annual depreciation expenses taken on a particular asset over the course of its life-to-date. For financial reporting purposes, accumulated depreciation is neither an asset or a liability. Instead, it is classified as a contra asset account and is used to reduce an asset’s value on the balance sheet to reflect the total amount of wear and tear on that asset to date.
For investors who are looking to sell one or more properties, accumulated depreciation can become a major factor that needs to be addressed with an accountant or tax attorney prior to completing the sale. The reason for this is that accumulated depreciation reduces the cost basis of the property, which can result in a gain upon the sale of the property.
Because an accounting concept like accumulated depreciation is complex, many investors who are interested in investing in commercial real estate choose to work with a private equity sponsor like us. A private equity sponsor has experienced professionals who handle the accounting for each property in the portfolio and help the management team to make informed buy and sell decisions to try to maximize the total return to investors after taking into account any tax liabilities.
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If you are an Accredited Real Estate Investor and want to learn more about our investment opportunities, contact us at (800) 605-4966 or info@fnrpusa.com for more information.
