Commercial real estate depreciation is perhaps one of the most underrated benefits of investing in commercial assets. Aside from the greater majority neglecting to recognize its existence, few people on the outside looking in can see past the profit margins that have become associated with commercial real estate.
Consequently, and to the surprise of many, commercial property depreciation is just as valuable as cash—if not more so. Acting as a tax shelter for savvy commercial real estate investors, commercial depreciation contributes to investors’ bottom lines by reducing their taxable wages, adding a whole new meaning to the phrase “addition by subtraction.”
Commercial real estate depreciation is a significant tax break awarded to qualifying commercial real estate owners. More specifically, however, commercial real estate depreciation is a powerful tax shelter designed to reduce the taxable income of investors who rent out commercial properties.
Not unlike standard business tax deductions, the Internal Revenue Service (IRS) allows qualifying owners of commercial real estate investments to reduce their tax bill by depreciating the value of their property over a set period of time. That’s an important distinction to make, as the entire value of the property can’t be written off in a single year.
Instead, the cost of commercial rental properties can be written off incrementally over the building’s “useful life,” which is more than 39 years for commercial properties. That means, investors who rent out commercial real estate may deduct a portion of the building’s original cost each year over the course of 40 or so years.
Accounting for depreciation at tax time will reduce one’s taxable wages and shelter their money from the government, effectively netting them more money each year. It is worth pointing out, however, that the benefits of commercial real estate depreciation are often compounded by a healthy market.
Commercial rental property owners are allowed to deduct depreciation each year over the building’s useful life, regardless of how well the market is doing. Therefore, when prices are appreciating over periods of prosperity, rental owners can simultaneously claim depreciation deductions while benefiting from the actual appreciation of their own asset.
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The first step in determining the amount commercial real estate owners may depreciate their property by each year is to calculate the asset’s basis. The basis of a property is essentially its acquisition cost, minus the cost of the land (land is not depreciable in the eyes of the IRS). While the cost of the actual land is excluded from the basis, commercial renters may include things like settlement fees, closing costs and additional out-of-pocket expenditures. There are, of course, guidelines the IRS will want you to follow when determining the basis for a property. For this reason, be sure to check with a certified tax professional to ensure you land on the correct basis for your own asset.
Once you are confident you have the correct basis for your property, proceed to choose which Modified Accelerated Cost Recovery System (MACRS) the IRS will want you to use to calculate your rate of depreciation. Renters will typically be forced to choose between two specific depreciation systems: the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). Investors generating rental income through a business entity typically resort to using the GDS, unless there is a specific reason the ADS makes more sense for their situation. The system you use will depend on the year your property was put in service.
Next, factor the previously discussed basis into the depreciation system your tax professional recommends, making sure to account for the amount of years you are able to deduct. A good commercial real estate depreciation calculator will look something like this:
Cost Of The Home – The Value Of The Land = The Basis
Basis / The Amount Of Years The Home May Be Depreciated = Yearly Allowable Depreciation
Investors may not account for depreciation the moment they buy the property, but rather the moment they put the property “in service,” as the IRS puts it. In other words, commercial rental property owners can’t start claiming depreciation until they start using it to generate rental income. That said, commercial depreciation will continue until one of two things happen:
The entire basis has been deducted
The property is removed from service
Commercial rental property depreciation will end when the owner has recovered the entire cost of the basis (the acquisition costs minus the cost of the land). However, it’s also worth pointing out that depreciation will end once a property is sold. The commercial property owner will no longer be able to claim depreciation once they “remove the property from service,” or simply, sell it.
Let’s say, for example a commercial real estate investor was to purchase an office building for $2,000,000. Subsequently, the land the building is located on is worth somewhere in the neighborhood of $600,000. Subtracting the value of the land, the investor will have a depreciable cost basis of $1,400,000.
A well-calculated and legal commercial real estate depreciation strategy is both an important tax shelter and invaluable investor tool. If for nothing else, commercial depreciation is just as important to an investor’s bottomline as their profits. Therefore, it is of the utmost importance to develop an understanding for commercial depreciation as soon as possible. Doing so is the only way to maximize returns in a given year and optimize profit margins.