For many, one of the primary attractions of a commercial real estate investment is the tax benefits that come with it. While many investors may be familiar with high profile tax benefits like 1031 Exchanges or the pass through structure of the limited liability company, they may not be as familiar with the concept of depreciation.
In this article, we are going to define what depreciation is, how it is calculated, why it reduces a real estate investor’s tax liability, and how it can be recaptured upon property sale. By the end, readers should be able to take this information and incorporate it into their property financial models.
First National Realty Partners is unique in the sense that we are a vertically integrated private equity commercial real estate investment firm. This means that we manage our own assets. In doing so, we are able to optimize the tax benefits of the deal – and investor returns – by taking the maximum amount of depreciation allowable under IRS rules. To learn more about our current investment opportunities, click here.
What is Commercial Real Estate Depreciation?
To illustrate the tax benefits of depreciation, it makes sense to begin by defining exactly what it is.
Depreciation is an accounting concept that allows a property owner to expense a portion of a property’s value each year to account for the deterioration in its physical condition. For example, a commercial building’s roof may have a useful life of 20 years. As such, the property owner can “depreciate” the value a little bit each year to account for the fact that the roof’s value slowly declines over time. The exact amount of allowable depreciation is governed by internal revenue service (IRS) rules.
How is Depreciation Calculated?
For tax purposes, the depreciation calculation is complex and it is not the intent of this article to describe it in detail. The specifics should be left to a qualified CPA. Instead, we will describe the depreciation calculation in general terms and there are two methods that are particularly relevant to commercial real estate investment.
Straight Line Depreciation
The easiest and fastest way to calculate the amount of allowable depreciation is to use the straight line method. With it, the value of the real property is divided by the estimated number of years in its useful life. For example, suppose that a property has a value of $10MM and an estimated useful life of 30 years. In this case, the amount of allowable annual depreciation would be $333,333 ($10,000,000 / 30).
While this calculation is perfectly acceptable, it is perhaps overly simplistic. A commercial property consists of many different components, all of which have a different useful life. For example, the carpet and interior finishes will likely wear out faster than a parking lot or roof. For this reason, many investors utilize a depreciation method known as “cost segregation” that allows them to maximize the amount of depreciation taken annually.
What is 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.
What Are the Tax Benefits of Depreciation?
Once the allowable depreciation expense has been calculated, it is listed as a line item on the property’s income statement. This expense acts as a tax deduction of sorts and reduces the amount of taxable income produced by the property. The table below illustrates this point:
|Line Item Description||No Depreciation||With Depreciation|
|Potential Rental Income||$100,000||$100,000|
|Effective Rental Income||$90,000||$90,000|
|Gross Operating Income||$105,000||$105,000|
|Other Operating Expenses||$12,000||$12,000|
|Net Operating Income||$48,000||$43,000|
|LESS: Debt Service||$18,000||$18,000|
This table highlights two scenarios, with and without depreciation taken. In the scenario without depreciation, the property produces $30,000 in pre-tax income. In the other scenario, $5,000 in depreciation is expensed, which reduces pre-tax income to $25,000. Lower pre-tax income means a lower tax liability.
However, it is important to note that the LLC structure means that this pre-tax income is distributed to individual investors/taxpayers who will each calculate their own tax liability when preparing their tax return. The exact amount due may vary by individual based on their calculated tax bracket.
While this may seem like a significant benefit, it is important for real estate investors to recognize that annual accumulated depreciation is “recaptured” and taxed when the property is sold.
What is Depreciation Recapture?
For a commercial rental property, depreciation is normally taken on an annual basis and it accumulates over many years. When a property is sold, accumulated annual depreciation is “recaptured” and subject to income tax. For many, this tax bill can come as a surprise. To highlight this point, consider the following example.
Assume that a property was purchased for $1 million and IRS rules allow $20,000 per year in depreciation deductions. After five years, the property’s depreciated cost basis has fallen $100,000 ($20,000 per year for five years) down to $900,000. At the same time, the property’s market value has increased and is sold for $1.25 million. The difference between the sales price and the cost basis is a “gain” and the portion that is attributable to depreciation is recaptured and taxed. For example, suppose $100,000 of the gain was attributed to depreciation and the tax rate is 25%. This would result in a $25,000 tax bill.
The key takeaway is this. While depreciation provides a major tax benefit on a year to year basis, it can also result in a surprise tax bill when a property is sold for a capital gain. To mitigate the impact, investors should work with their CPA to plan for it.
Using Commercial Real Estate Depreciation to Your Benefit
Whether investing in commercial real estate on your own or with a private equity sponsor, it is always in the investor’s best interest to maximize the amount of depreciation that is taken each year while ensuring compliance with all applicable tax laws. Doing so will decrease individual tax liability.
If investing in commercial real estate individually, this can be accomplished by working with a qualified CPA or tax attorney who can advise on the steps necessary to maximize depreciation. If working with a private equity sponsor, it is important to ask them what steps they take to maximize depreciation. At a minimum, they should be working with a tax attorney themselves and pursuing a cost segregation study when appropriate.
Summary & Conclusion
Depreciation is an accounting concept that allows property owners to expense a portion of an investment property’s value each year to account for its physical deterioration.
There are several methods that can be used to calculate the amount of allowable depreciation, one of which is known as the “straight line” method which divides a property’s value by the estimated number of years in its useful life. Another common method is known as the modified accelerated cost recovery system (MACRS).
Because depreciation provides tax savings, property owners are incentivized to maximize the amount taken each year. One of the ways this is accomplished is by employing a cost segregation study, which separates the components of a property and depreciates them over different time periods.
However, commercial real estate investors must be aware that depreciation can accumulate over a long period of time. Upon sale, this depreciation is recaptured and subject to income tax. For those unaware of this requirement, the tax bill can come as a surprise.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you are an Accredited Real Estate Investor and would like to learn more about our investment opportunities, contact us at (800) 605-4966 or firstname.lastname@example.org for more information.