Depreciation is used by investors in order to recover the cost of a commercial income property and increase its net operating income.
Depreciation assumes that there is a loss in value of a property due to physical deterioration of the property, which creates significant tax breaks for the owner.
While land itself doesn’t depreciate, there are numerous assets that are considered eligible, and over the year, a savvy investor can reduce taxable income by thousands of dollars. Of course with the IRS, there is always a disadvantage, and in the case of depreciation, the amounts that you claim will increase the taxable profit declared when the property is sold.
Therefore, it is critical that investors make sure to claim the correct amount of depreciation each year, especially since the IRS will assume you’ve already claimed it starting from the sale of the property.
What Items Can Be Depreciated?
Here’s a list of common assets you can claim depreciation for your commercial property:
- roof replacement
- new HVAC system
- capital improvements
- landscaping improvements
- new windows
- leasehold improvements
- equipment used to maintain the property
You cannot depreciate repair costs or service contracts, although these can be deducted as expenses.
How Long Does Depreciation Last?
Another important fact is that different types of assets have different depreciation schedules. Commercial properties – meaning the building itself -depreciate over a period of 39 years, while objects within the building (other than furnaces, which carry a schedule similar to the property itself) such as equipment possess a five or seven-year depreciation schedule due to their limited lifespan.
How Is Depreciation Calculated?
In order to determine the exact amount to be depreciated, the straight-line method of depreciation is used. This sum is arrived at by subtracting the buildings salvage value from the cost of construction or purchase and then dividing that number by the number of useful years left to the building. The resulting sum is called the annual fixed depreciation amount, and it is this amount which can be deducted each year until the property reaches the end of its useful life; i.e. deprecation is complete.
Salvage value is the amount a building would get if it were no longer useful; i.e. at the end of its useful life. This number can vary, depending on how hard you are on the property, and how long you use it.
Salvage value differs from market value, however, in that market value is the amount of money you could get by selling it now.
What Happens If I Sell The Property?
Selling your property will cause you to be liable to be taxed at two different rates. That is because both your adjusted cost basis and the property’s selling price will be used to determine how much you owe in taxes.
Your adjusted cost basis is used to determine the profit or loss on the property. It is calculated by adding the original purchase price to whatever costs were incurred for capital improvements. Then the amount that was depreciated until the sale is subtracted.
This process is termed “depreciation recapture” and is a result of gaining additional profit due to claiming depreciation.
