Depreciation
Depreciation is the loss in value of an asset / building over time due to wear and tear, physical deterioration and age. The cost of reproducing an income property can be recovered over the useful life of the asset which is determined by law. Depreciation is treated as an expense and is a line item on an income statement. Depreciation can only be applied to the building and not the land, since land does not wear out over time. Residential income property must be depreciated over a 27.5 year period using straight line depreciation. Commercial income property must be depreciated over 39 years using straight line depreciation. Straight line depreciation stipulates that an asset must be depreciated by equal amounts each year over its useful life.
Example: You purchase a warehouse for $900,000. The land where the warehouse resides is valued at $120,000. The building is valued at $780,000. Current law allows you to depreciate commercial properties by equal amounts annually over 39 years. Your depreciation deduction for the first year is based on the mid month convention. The day of the month that you purchase the property doesn’t matter. You can only deduct half of the first months depreciation. If you put the warehouse into service on June 1, you are allowed to deduct 6 and 1/2 months of depreciation for the first year.
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$780,000
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=
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$20,000 |
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39
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Accountants calculate a full year of depreciation for the above warehouse (commercial properties) by multiplying 2.56 % times $780,000 which equals 19968. A full year of depreciation for residential income properties would be calculated by multiplying 3.64 % times the building basis.
The depreciation deductions that you write-off in any year reduce your taxable income thus increasing your profit for that year.
Capital improvements are subject to the same depreciation laws. Capital improvements include the following; a new roof, a new furnace, an addition to a building, siding, etc.
Example: You have owned the above warehouse for about 7 years now and it is in need of a new roof. The cost of the new roof is $19,500. You are allowed to depreciate the cost of the roof over 39 years. If you put the new roof on in July, you are allowed to deduct 5 and 1/2 months of depreciation in the first year.
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$19,500
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=
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$500 |
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39
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Accountants would calculate a full year of depreciation for the roof by multiplying 2.56 % times $19,500 which equals $499.
All depreciation amounts that you write-off in each year for the building and capital improvements reduce your adjusted basis for the property thus increasing the taxable profit you must declare when you sell.
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