Depreciation is used by real estate investors, including triple-net (NNN) lease investors, to recover the cost of a commercial income property and increase net operating income (NOI). Depreciation assumes there is a loss in value due to physical deterioration of the property, which creates significant tax opportunities for the owner.
In this article, we’ll explain the different types of depreciation and how to know if your property qualifies, what can be depreciated, how it may work in your favor, and how to recapture depreciation in a 1031 exchange.
Please note, Westwood Net Lease Advisors are not giving tax advice. This is simply informational and meant to help clarify terminology. It is recommended you consult your CPA or tax advisor for verification of your individual situation.
Different Types of Commercial Depreciation: Straight Line & Cost Segregation
While the land your NNN lease building sits on doesn’t depreciate, there are numerous assets of the property that are eligible. Over the course of a year, by taking depreciation, you can reduce taxable income by thousands of dollars.
Therefore, it is critical to make sure you claim the correct type and amount of depreciation each year to maximize your internal rate of return (IRR).
Straight Line Depreciation
Straight line depreciation, or “straight line basis,” is the most straightforward way to estimate the loss of value of your NNN property over time. To get your depreciation figure, which in this type of depreciation is a fixed number, divide the difference between the property’s cost and its expected salvage value by the number of years it is expected to be used.
The expected salvage value (ESV) is the amount a building would be worth if it were at the end of its useful life. This number can vary, depending on how the property is used and for how long. For example, an auto parts store may have a somewhat shorter useful life than a coffee shop, as daily wear-and-tear could be higher. Your CPA or tax accountant would have an idea of what this figure would be.
Also, keep in mind, ESV differs from market value; market value is the amount of money you could get by selling it now.
To calculate straight line depreciation, follow the simple steps in this example:
- Take the cost of the property minus the ESV to get your depreciation cost: $100,000,000 – $200,000 = $800,000 depreciation cost
- Figure the useful life of property: 20 years
- Divide the depreciation cost by those years for your potential annual depreciation amount: $800,000/20 years = $40,000 annual fixed depreciation amount
The resulting sum is the annual fixed depreciation amount that can be deducted on your taxes each year until the property reaches the end of its useful life, i.e. the deprecation is complete, or you sell the property. All types of properties, except ground lease properties, can qualify for this type of depreciation.
Cost Segregation Depreciation (CSD)
Cost segregation depreciation may allow nonstructural improvements such as indoor and outdoor lighting, heating and cooling systems, and parking lot and landscaping, to be depreciated over five, seven, or 15 years, versus 39 years.
This substantially shorter depreciable tax life helps you preserve capital, realize immediate cash flow, and achieve significant tax relief on new and existing buildings. These benefits are also gained through asset reclassification and write-offs when the asset is sold. In summary, CSD allows you to:
- Adjust the timing of deductions to maximize tax savings.
- Swiftly depreciate expenses.
- Reduce/defer current tax liability.
- Increase cash flow for other investment opportunities or operating expenses.
- Take 100% of the adjustment (on buildings purchased after September 2017) in one year, i.e., bonus depreciation.
- Reclaim deductions dating back to 1987 without having to amend tax returns.
- Create an audit/paperwork trail that satisfies the IRS’s audit techniques guide (ATG).
“The benefits of cost segregation, which are relatively unknown by a majority of investors, can be substantial and immediate, especially in recent years with accelerated ‘bonus depreciation.’ Cost segregation is one of the biggest tax benefits available to an investor.” – Jason Simon, Vice President, Westwood Net Lease Advisors.
The only way to determine if your NNN property qualifies for the maximum CSD benefit is to have engineering, architecture, construction, or tax accounting specialists perform a cost segregation study (CSS). A CSS is performed when buying a new building, but it can also be performed on a building owned for many years. New deductions can be taken back to 1987 without amending tax returns.
A study is also advantageous when you finish new construction or complete redevelopment or renovation of an existing building. To satisfy the IRS’s strict CSD guidelines, it’s imperative that your CSS is performed by a highly accredited firm that determines the cost estimates and allocations in accordance with the law. This also ensures you don’t leave any money on the table.
What Items Can Be Depreciated?
When you own a commercial property, these are common, nonstructural improvements or assets that can be depreciated at tax time. When you own an absolute NNN lease property, the tenant generally takes care of all of the following, unless otherwise stated in the lease. However, be sure to check with your tax professional to maximize your individual situation.
- 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 Can I Take Depreciation as a Tax Benefit?
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 possess a five-, seven-, or fifteen-year depreciation schedule due to their limited lifespan. The shorter depreciation life of the nonstructural items would most likely be determined by your CSS.
“Many accountants are familiar with cost segregation, but few understand and have the capability to help their clients fully execute the benefits of it. We have relationships with cost segregation specialists and help put investors in a position to maximize the tax benefits cost segregation offers.” Jason Simon, Vice President, Westwood Net Lease Advisors
What Happens If I Sell the Property or Utilize a 1031 Exchange?
When selling your property, you may 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.
When the sale price of a property exceeds the tax basis or adjusted cost basis, the difference is “recaptured” by reporting it as income.
Now, if you choose to sell your investment property and utilize a 1031 exchange, you can invest the proceeds from the sale of your commercial property into a similar or “like-kind” property within 180 days and defer the capital gains and depreciation recapture taxes on those profits.
In a 1031 exchange, deferring the capital gains tax could mean a potential savings of up to 20%, and a deferral of the depreciation recapture tax could provide an additional 25% savings. As you can see, utilizing the 1031 exchange means a significant amount of capital can be freed up to reinvest later.
To Wrap It Up – Depreciation Can Help Provide a Higher IRR
Knowing which type of depreciation will give you the most favorable IRR is important when you own a commercial property and when you purchase an investment property. When buying in a 1031 exchange, the tax opportunities of the exchange plus the depreciation recapture, along with a CSS on a new or existing building, will provide a clearer picture of your capital preservation and return over the life of the investment.
The Westwood Net Lease Advisors team has decades of NNN lease property experience and always helps clients decode the depreciation and capital preservation opportunities when searching for their ideal properties. We provide objective advice, education, knowledge, advocacy, and professional resources – all without any cost to you! Our advisors can help you with the details and make it simple to utilize depreciation and the different tax laws for your next investment. Contact us today for a no-obligation consultation – we’re here to help. 314-997-5227commercial property depreciation, cost segregation depreciation, NNN tax benefits, straight line depreciation