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Commercial Real Estate Depreciation

May 17, 2024

Commercial real estate depreciation refers to the tax deduction that property owners can take for the wear and tear or deterioration of a commercial property. For real estate investors, understanding commercial real estate depreciation is crucial to be able to utilize the best tax strategies to maximize their investments.

With a 1031 exchange real estate depreciation recapture strategy you can recover the tax benefits you’ve received from depreciation when you sell the property without immediately paying taxes on the gain, provided you adhere to specific rules and timelines.

Our experienced qualified intermediaries at Universal Pacific 1031 Exchange are committed to helping you maximize your investments through smart 1031 tax-deferred strategies that grow your portfolio. Book a free consultation with us today to get started.

This guide will walk you through everything you need to know about depreciation in the context of commercial real estate, including how it works, the types available, and strategies to maximize benefits while minimizing taxes.

What Is Commercial Real Estate Depreciation?

What Is Commercial Real Estate Depreciation?

Commercial real estate depreciation is the process of allocating the cost of a tangible asset over its useful life. In the context of taxes, depreciation is an accounting method to allocate the cost of the property over its useful life for tax purposes. However, there are many factors affecting deprecation and how commercial real estate investors can utilize this to maximize their portfolios, such as the type of property, useful life of an asset and salvage value. It’s important to note that not all assets can be depreciated. Land, for instance, doesn’t depreciate because it doesn’t wear out.

For commercial real estate, the IRS generally sets an average of 39 years for the useful life of an asset (the period over which it is expected to be usable for its intended purpose). Salvage value is the estimated residual value of an asset at the end of its useful life and in the case of commercial real estate, this is often minimal or zero.

Understanding depreciation and how to utilize it in investments is crucial if you own or are considering investing in commercial properties.

What Is Depreciation Recapture?

When you own a commercial property, commercial real estate depreciation can be a powerful tool to reduce your taxable income each year since it allows you to spread out the cost of the property over its useful life, providing an annual tax deduction that reflects the property’s wear and tear. However, this benefit comes with a catch known as depreciation recapture.

Depreciation recapture occurs when you sell a property that has been depreciated. Essentially, it’s the IRS’s way of reclaiming some of the tax benefits you received from those depreciation deductions over the years. Each year, you can deduct a portion of the property’s cost as depreciation, reducing your taxable income. This means you pay less in taxes now, which improves your cash flow and allows commercial real estate investors to reinvest or save money.

Selling the Property – When you decide to sell your property, the IRS takes a closer look at the depreciation you’ve claimed. The depreciation recapture rule states that the portion of the gain on the sale of the property that is attributed to the depreciation deductions you’ve taken must be “recaptured” and reported as taxable income.

Ordinary Income Tax Rates – Unlike regular capital gains, which are typically taxed at lower rates, depreciation recapture is taxed as ordinary income. This means it could be subject to higher tax rates. For example, if you’re in a high tax bracket, the recaptured amount might be taxed at rates up to 37% (as of 2024), compared to long-term capital gains rates which max out at 20%. The recaptured amount is also taxed as ordinary income, not as commercial real estate capital gains.

How To Calculate Commercial Real Estate Depreciation?

How To Calculate Commercial Real Estate Depreciation?

The IRS has strict guidelines on how depreciation should be calculated. This includes using the MACRS method for most properties and following specific recovery periods. Depreciation should be tracked using a depreciation schedule, which outlines the annual deductions and remaining value of the asset.

For a $1 million commercial building with a 39-year useful life and no salvage value, the annual depreciation using the straight-line method would be approximately $25,641.

Case Study For Calculating Real Estate Depreciation

Imagine you bought a commercial building for $1,000,000 and over 10 years, you claimed $250,000 in depreciation deductions. This lowered your taxable income and saved you money on your taxes each year. After 10 years, you sell the property for $1,500,000. Here’s how the taxes might break down:

  • Your total gain is $1,500,000 (sale price) – $1,000,000 (purchase price) = $500,000.
  • The IRS will recapture the $250,000 in depreciation deductions. This amount is taxed at your ordinary income tax rate.
  • The remaining $250,000 gain ($500,000 total gain – $250,000 depreciation recapture) is taxed as a capital gain.

By understanding depreciation recapture, you can plan better for the tax implications of selling a depreciated property.

This knowledge allows you to consider strategies like 1031 exchanges, which can defer the recapture tax if you reinvest the proceeds into a similar property, which helps you to continue to defer taxes and keep more of your money.

Advantages of a 1031 Tax-Deferred Exchange

Advantages of a 1031 Tax-Deferred Exchange

A 1031 exchange, also known as a like-kind exchange, is a real estate strategy that lets you sell and defer capital gains taxes when you swap one investment property for another like-kind replacement property. Aside from the standard type of tax deferring exchange, you also have other 1031 exchange options to match different kinds of portfolios and needs.

When you exchange a property with a 1031 tax-deferred exchange the depreciation recapture is deferred along with the capital gains. The new property inherits the basis and depreciation schedule of the old property. Furthermore, any additional funds used in the purchase are added to the basis rather than going to the IRS (Internal Revenue Service) in terms of collected taxes.

By reinvesting the proceeds into another property through a 1031 exchange and deferring capital gains tax, you get your investment to grow without immediate tax liability.

What Are 1031 Exchange Rules To Keep in Mind When Deferring Taxes?

Under the 1031 exchange rules, you must reinvest the proceeds from your sold property into a like-kind property. For commercial real estate, like-kind generally means any real property held for investment. For example, you can exchange a corporate office building for an apartment complex (like-kind doesn’t mean identical).

How Many Like-Kind Properties Can You Identify?

On average, you can identify three properties or more than three properties if their combined value does not exceed 200% of the relinquished property’s value. Alternatively, you can identify any number of properties if you acquire 95% of the total value of the identified properties.

In addition to that, the replacement property must be depreciated based on the adjusted basis of the old property (original cost minus depreciation taken). Any additional capital invested into the new property can be depreciated separately.

1031 Exchange Timeline Rules

You have to identify potential replacement properties within 45 days of selling your relinquished property (identification period). You can identify up to three properties without regard to their value or any number of properties as long as their combined value does not exceed 200% of the relinquished property’s value. You then have 180 days from the sale of the relinquished property to close on the replacement property. This is known as the exchange period.

Types of Real Estate Depreciation

Types of Real Estate Depreciation

Understanding the various methods of real estate depreciation is crucial for effectively managing your investment properties and optimizing your tax benefits.

Choosing the appropriate depreciation method depends on your financial strategy and how you want to manage your tax obligations. There are three primary types of depreciation: Straight-Line Depreciation, Accelerated Depreciation, and Sum-of-the-Years’-Digits.

  • Straight-Line is ideal if you prefer simplicity and predictability.
  • Accelerated Depreciation (like DDB) suits those looking for immediate tax relief and better initial cash flow.
  • SYD offers a balanced approach, matching higher initial deductions with the declining utility of the asset.

Here’s a closer look at these three primary types of depreciation:

Straight-Line Depreciation

This is the simplest and most common method. It allocates an equal amount of the property’s cost as an expense each year over its useful life. It is predictable and easy to calculate but does not reflect the actual wear and tear which might be higher in the initial years of the property’s use.

How Straight-Line Depreciation Works

Formula: Annual Depreciation=Cost of the Asset−Salvage ValueUseful Life\text{Annual Depreciation} = \frac{\text{Cost of the Asset} – \text{Salvage Value}}{\text{Useful Life}}Annual Depreciation=Useful LifeCost of the Asset−Salvage Value​

Example: If you purchase a commercial property for $1,000,000 with no salvage value and a useful life of 39 years, your annual depreciation would be: 1,000,000−039=$25,641\frac{1,000,000 – 0}{39} = \$25,641391,000,000−0​=$25,641

Accelerated Depreciation

Accelerated Depreciation

Accelerated depreciation allows for larger depreciation deductions in the early years of the asset’s life, reflecting higher initial wear and tear. This method is more complex but can provide substantial tax benefits by deferring larger amounts of tax liability.

Types of Accelerated Depreciation

  1. Double Declining Balance (DDB)The Double Declining Balance method applies a constant rate to the declining book value of the asset, resulting in larger depreciation expenses in the initial years. It offers higher deductions in the early years, which can improve cash flow but is more complex to calculate and can result in lower deductions in later years.
    • Formula: Annual Depreciation=Book Value×2Useful Life\text{Annual Depreciation} = \text{Book Value} \times \frac{2}{\text{Useful Life}}Annual Depreciation=Book Value×Useful Life2​
    • Example: For a $1,000,000 property with a useful life of 39 years, the first-year depreciation would be: 1,000,000×239≈$51,2821,000,000 \times \frac{2}{39} \approx \$51,2821,000,000×392​≈$51,282
  2. 150% Declining BalanceSimilar to the DDB method but uses 150% instead of 200%. It provides moderate acceleration compared to DDB and is less aggressive, balancing higher deductions early on with more gradual declines.
    • Formula: Annual Depreciation=Book Value×1.5Useful Life\text{Annual Depreciation} = \text{Book Value} \times \frac{1.5}{\text{Useful Life}}Annual Depreciation=Book Value×Useful Life1.5​
    • Example: For a $1,000,000 property with a useful life of 39 years, the first-year depreciation would be: 1,000,000×1.539≈$38,4611,000,000 \times \frac{1.5}{39} \approx \$38,4611,000,000×391.5​≈$38,461

Sum-of-the-Years’-Digits (SYD)

The Sum-of-the-Years’-Digits method is another form of accelerated depreciation that applies a fraction to the depreciable base. This fraction is calculated based on the sum of the years of the asset’s useful life. This method provides a realistic allocation of depreciation based on the expected wear and tear of the asset but is more complex than straight-line, requiring careful calculation each year.

How Sum-of-the-Years’-Digits Works

Formula: Annual Depreciation =(Remaining Life/Sum of the Years)×(Cost of Asset−Salvage Value)\text{Annual Depreciation} = (\text{Remaining Life} / \text{Sum of the Years}) \times (\text{Cost of Asset} – \text{Salvage Value})Annual Depreciation=(Remaining Life/Sum of the Years)×(Cost of Asset−Salvage Value)

Sum of the Years: Sum of Years=Useful Life×(Useful Life+1)2\text{Sum of Years} = \frac{\text{Useful Life} \times (\text{Useful Life} + 1)}{2}Sum of Years=2Useful Life×(Useful Life+1)​

  • Example: For a $1,000,000 property with a useful life of 39 years:
    • Sum of the Years: 39×402=780\frac{39 \times 40}{2} = 780239×40​=780
    • First-Year Depreciation: 39780×(1,000,000−0)=$50,000\frac{39}{780} \times (1,000,000 – 0) = \$50,00078039​×(1,000,000−0)=$50,000
    • Second-Year Depreciation: 38780×1,000,000=$48,718\frac{38}{780} \times 1,000,000 = \$48,71878038​×1,000,000=$48,718

How To Report Depreciation

How To Report Depreciation

Reporting depreciation accurately on your tax returns is essential for optimizing tax benefits and avoiding potential penalties. You can report your 1031 exchange on your tax return on Form 8824 Like-Kind Exchanges. The IRS form 8824 contains four sections where you’ll provide information about the exchange as required.

To avoid facing challenges, hire a Certified Public Accountant (CPA) or tax adviser. They understand tax implications and can structure your exchange to ensure compliance with tax rules. Also, a tax accountant and CPAs accurately document your tax returns and financial statements in a 1031 exchange.

Need Advice on Deferring Real Estate Taxes?

Understanding commercial real estate investment depreciation is crucial for any property investor looking to maximize their investment returns and manage tax liabilities effectively. Depreciation provides significant tax advantages by allowing you to spread the cost of a property over its useful life, thereby reducing your taxable income each year. However, it also comes with complexities, especially when selling a property, due to depreciation recapture.

Navigating the intricacies of real estate depreciation and tax deferral strategies requires expertise. A qualified Intermediary or CPA can help you start a 1031 exchange, better navigate real estate deprecation, and advise you on tax-deferring strategies that build your investment portfolio.

Contact us today for a free consultation!

About The Author

Michael Bergman, CPA
Michael Bergman is a California licensed CPA and Real Estate Broker with over 32 years of experience in commercial real estate. Specializing in 1031 tax-deferred exchanges and financial oversight, his expertise is invaluable for complex real estate transactions. Michael’s unique blend of financial acumen and real estate knowledge positions him as a trusted advisor in the industry, offering sound advice and strategic insights for successful property management and investment.

Don’t let taxes hinder your property investment decisions. Connect with us today for a free, no-obligation 1031 exchange consultation. Let us help you navigate the process with ease.