Depreciation of Real Estate (Part 1)
Depreciation of assets is a topic that, in theory, is very straightforward to explain, but once it is incorporated into the tax code it gets complicated really fast. For this reason (and to ensure your sanity by not exposing you to too much tax code at once), we will break this discussion down into two posts. This first will deal with the basics of depreciation under the tax code, and a second will go into a little more detail on different sections of the code and the new regulations regarding what is considered a capital expense and what can be written off immediately.
In order to facilitate the discussion of depreciation, it is probably best to define some terms that accountants (and the IRS) use to describe certain business transactions:
Capital assets are purchased to contribute to the business’ profits for more than one year. The most typical items that fall into this category of assets are land, buildings and equipment. Since a capital asset will be used to derive income for many years, its cost cannot be taken as a tax deduction in the year of purchase, but must be written off over time. Accountants call this the “matching principle”, i.e. the write-off of the cost of the asset is matched to the stream of income it produces over the life of the asset.
Depreciation is the amount of the “cost” of an asset that is allowed to be taken as a deduction each year on a tax return. If you are wondering why I have put the word “cost” in quotations, it is because what is included in the cost number used for depreciation purposes is not necessarily the amount paid for the asset (that would be too easy!).
Just to throw another curve at you, not all capital assets get depreciated over their useful life. Land is one such asset. Because land does not wear out, become obsolete, or get used up, the IRS will not allow you to depreciate it, i.e. take a tax deduction for its cost. The value of the land will remain as an asset on the business’ balance sheet until such time as it is sold.
To put this into perspective for a real estate investment, the value of the land a rental property sits on must be subtracted from the “cost” of the property in order to calculate the amount of depreciation that can be written off on a tax return in a given year. Unfortunately, even though the business had to pay for the land the building sits on, there is no tax deduction for this cost until such time as the property is sold (we’ll discuss that in a later post).
The IRS is flexible as to how the value of the land is separated out from the purchase price of the property, but the method used needs to at least be supportable by facts. The two most common allocations used are: 1) based on the property tax assessment of the property and 2) based on a fair market value appraisal of the property at the time of purchase.
I keep putting the word “cost” in quotations because the IRS actually uses a different term to refer to value, and that term is “basis”. The basis of real property is its cost plus amounts paid for other items such as legal and recording fees, abstract fees, title insurance, survey charges, and certain other amounts that the buyer agrees to pay for. (Some other items may not be depreciable, but can sometimes be taken as deductions in the current tax year).
Anything the IRS includes in the “basis” of the property will be written off over the lifetime of the property (excluding the value of the land) as depreciation. It is also important to bear in mind that the “basis” of the property is independent of how the property was paid for. Financing a property through a mortgage will result in tax deductions for interest payments and some other fees, and will not affect the amount that is written off over time through depreciation. This is an advantage for equity investors using leverage, since they are getting the same amount of depreciation write-offs with a lesser amount of invested equity.
I think the easiest way to understand these concepts is with a simple example:
A rental property is purchased for $500,000, of which amount the land constitutes $100,000. The buyer pays for the property with $100,000 cash and a $400,000 mortgage. The buyer also pays the following amounts as part of acquiring the property: legal fees of $2,000; title insurance of $6,000; survey fees of $2,000; casualty insurance of $3,000, an appraisal fee for the lender of $1,000 and a mortgage origination fee of $500. What is the “basis” of the property? And what is the amount that will be depreciated over time?
The basis of the property is calculated as follows:
|Basis in the property||$508,000|
The amount that will be subject to depreciation over time, however, is not $508,000, but that portion that is attributable to the non-land components of the purchaser, since land cannot be depreciated. This applies also to the $8,000 of fees; a portion of them are attributable to the land portion of the purchase. If the land is valued at $100,000 of the $500,000 purchase price, you must allocate to the value of the land (100,000/500,000) x $8,000 = $1,600 worth of fees. Therefore, the amount that will be subject to depreciation over the life of the asset is (508,000 – 100,000 – 1,600) = $406,400. The remaining $101,600 cannot be depreciated until the asset is sold.
Again, none of these calculations were dependent upon whether or not any financing was in place, pointing to an advantage in leveraging (incurring indebtedness on) a property.
We will leave details about how depreciation is calculated, and the new regulations about what gets included in basis vs. what is written off immediately, for our next post.