4 Points to Master Commercial Real Estate Depreciation
Written by,
Rick Dimidjian President & Broker of Record
Camryn Ruby Director of Marketing & Business Development
14 November 2022
Commercial Real Estate investors can take advantage of government incentives like depreciation when they purchase a property. One common reason these government incentives are often forgotten is that some CRE investors do not fully understand the benefits of the depreciation expense in real estate. Sure, depreciation is a term thrown around in this industry, but many investors, perhaps new CRE investors, do not know the value it can actually bring to their investments. To begin, depreciation is to be understood as a capital expense that recovers your costs in an income-producing property and must be taken over the expected lifespan of the property. Depending on the property type, depreciation will be practiced differently.
AKA Phantom Expense
A phantom expense is a perfect example of depreciation because it allows the CRE
buyer to deduct the depreciation expense from taxable income instead of paying cash out of pocket. For many CRE investors, especially if they put debt on the property, this phantom expense can shield any sort of taxable income that you hopefully made from the real estate investment. There are important details to know before claiming your tax benefits. Now, let’s get into our top 4 rules to be followed for mastering the incentives of your investment property.
POINT #1
Let’s assume you just bought your first CRE investment and you want to begin revamping your newly purchased property. Rule number one to follow is that you are only able to depreciate improvements on the land of the property. So, over time the building may begin to depreciate from wear and tear, but the land itself is not going to depreciate. Actually, the land may appreciate over time instead. The bottom line is that you can only take depreciation expense based on the value allocated to the improvements on that land. So how do you know the accurate amount that you need to depreciate?
POINT #2
Always do the math. You will need to know the right amount to depreciate over the overs. It is important to note that commercial real estate’s general recovery period is 39 years. So, to calculate the right amount to depreciate you will take 1/39th or 2.6% each year of the value of improvements and add that as a depreciation expense on your property every year.
This method for calculating the amount of depreciation expense per year is considered straight-line depreciation. This means that amount stays the same from year to year. Now, when the investor looks closely at the newly purchased property, they may have a few other opportunities to collect even more benefits.
POINT #3
Understand the modifications to maximize the tax deduction. The straight-line method is great, but sometimes there are modifications. The first modification is done through an accelerated depreciation approach. Once the investor buys a piece of income-producing property, the improvements are the investor’s responsibility. Improvements can be made to three areas including the land, the building structure, and the contents inside the building.
The land’s improvements may be new lighting for the parking lot or fencing around the building. As for the building contents themselves, improvements may be flooring, new windows, or new fixtures. The building structure itself will depreciate between 27.5 and 39 years. The land improvements can depreciate over a shorter period, of 15 years. Then, the building contents can depreciate for as little as 5-7 years. These timeframes are extremely important for investors to recognize because the investor can benefit from a much bigger depreciation deduction in just the first few years of ownership. Also, if the investor only plans to know that property for a few years, this is a huge tax benefit for the investor.
POINT #4
A Cost Segregation Study is required to use the modifications above. This study will be conducted by hiring a team of CPAs and engineers. Now, this may look expensive on the outside, but you will actually save money in the long run due to the tax savings. So, investors should try not to worry about the upfront cost because the deductions will offset the cost of hiring those professionals, completely. Now, a new rule was enacted through the tax cuts and Jobs Act in 2017 called bonus depreciation. The new rule allows the investor to depreciate up to 100% of its qualifying real estate expenditures in the 1st year of owning the property. The qualifying expenditures include anything with a useful life of under 20 years. So, if you refer back to Point #3, the land improvements and the building contents can now be depreciated 100% in that first year.
Listen up, this rule has a catch called the depreciation recapture tax. This means, when the investor tries to sell the property, the investor is required to pay the rate for the depreciation recapture tax which is 25%. So, for all of the depreciation that the investor took, they will have to pay back 25% in taxes. To defer some of that 25%, the investor can do a 1031 exchange. The investor needs to evaluate all angles of the improvements and their calculations before depreciating them. With the help of a team of CPAs and Engineers, this will be extremely beneficial for the investor.
Why Stick to the Rules?
Real estate is one of the most taxed-advantaged investment vehicles in the United States, so investors must understand how to maximize their depreciation. Normally, our US government structures its tax codes to incentivize certain behaviors that are good for the overall economy. So, buying and selling private commercial property is one of those good behaviors. These tax benefits are put into place so the investor can create appreciation for their properties. The more an investor understands their options and their financial situation, the greater the success rate; so stay involved and keep referencing our blog posts to learn more.
Aegis Realty Partners Real Estate Investment specialists are well-positioned to advise our investors to seek out new real estate acquisitions as well as assist real estate investors when it comes to selling their properties, and can advise investors on some of the most attractive financing options for their acquisition or refinancing needs.
Aegis Realty Partners Property Management services manages thousands of square feet of commercial property and over 1000 residential units, and there isn't a type of property that we are not familiar with. If you or you know of any investor that needs assistance in choosing a property to invest or manage in we are willing to discuss our professional investment brokerage and/or management services. We are in constant communication with investors actively looking to buy, sell, and lease properties.
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