Commercial investors use depreciation as a method of lowering the amount of taxes paid on an income property.
Depreciation allows the owner to deduct a percentage of the cost of a tangible asset over a specified period of time. This allows you to recover the cost of the property through tax deductions. So for example, if you purchased a commercial property for $2.5 million dollars, then you would divide that number by 39 years. The total, $64,102, is the amount you would be able to take off your taxes on a yearly basis.
The IRS does not allow investors to write off the cost over a year’s time, instead investors write off a percentage of the property’s value over time. In the case of commercial property, the time period is generally 39 years for most items, although a cost segregation analysis will break out which items can be depreciated earlier.
Here is a list of of items that can be depreciated:
Improvements to the property such as new septic systems or an electrical system overhaul are also included, as are landscaping improvements and legal fees (if separated from the original purchase price).
Some items you can’t depreciate:
- service contracts
- the land the property sits on
Leasehold improvements, which are improvements made on a property for tenants, can be depreciated, and are typically depreciated over 15 years instead of 39.
That’s because the IRS realizes that any changes made to a property for a tenant won’t last long, since improvements need to be made to the property whenever a new tenant signs a lease.
In addition, if a tenant moves out before the 15 year period is up, the landlord can choose to write off the entire amount of leasehold improvements and receive it all as one sum.
One important fact about depreciation to remember: depreciation can catch up with you when you decide to sell your property. Your profit on the sale is determined by your adjusted cost basis, which is the original purchase price of the property, plus capital improvements – minus the amount of depreciation claimed.
If the amount you receive for the sale is equal to or more than the purchase price, then you’ll end up paying a depreciation recapture rate of 25% and a capital gains tax of 15% or 20%, depending on your tax bracket.
However, you can avoid paying a capital gains tax if you utilize a specially structured 1031 exchange.
Tags: capital gain taxes, commercial real estate, income property, IRS, real estate properties, triple net lease property