Definition
Component Depreciation
Component Depreciation is a method used in real estate taxation whereby a property’s improvements are separated into distinct categories such as the roof, plumbing, electrical system, and building shell. Each component is depreciated individually over its useful life. This method can provide more accurate tax deduction benefits compared to depreciating the entire property as a single asset.
Historical Context
Component Depreciation was eliminated in the United States by the Economic Recovery Tax Act of 1981 (ERTA) for acquisitions made after 1980. However, understanding the methodology remains crucial for certain tax strategies and depreciation approaches.
Detailed Example
Example 1: Commercial Property
A commercial building purchased in 1979 undergoes component depreciation. The roof, expected to last 20 years, is depreciated over its remaining useful life, giving a separate deduction from the plumbing, electrical system, and building shell, which each have varying useful lives.
Example 2: Residential Property
A multi-family residential property acquired in 1980 utilizes component depreciation. The electrical system is upgraded in 1985 with a projected useful life of 15 years. Each line item, such as new plumbing fixtures or new roofing material, is calculated for depreciation based on its independent useful lifespan.
Frequently Asked Questions (FAQs)
What are the benefits of Component Depreciation?
Component depreciation allows property owners to better match the cost of property improvements against their actual usefulness and longevity, potentially leading to higher initial tax deductions.
Why was Component Depreciation eliminated?
Component Depreciation was eliminated by the Economic Recovery Tax Act of 1981 to simplify the tax code and align depreciation practices more closely with broader economic goals, such as stimulating investment through accelerated cost recovery systems.
Can component depreciation be used for recent property acquisitions?
No, component depreciation is no longer permissible for property acquisitions made after 1980. The Modified Accelerated Cost Recovery System (MACRS) is used instead.
Are there any similar methods practitioners use today?
Today, property owners and tax professionals use Cost Segregation Studies — a method akin to component depreciation — to identify personal property assets within a building that can be depreciated faster.
Related Terms with Definitions
Cost Segregation
A tax strategy allowing companies and individuals who have constructed, purchased, or remodeled real estate to increase cash flow by accelerating depreciation deductions and deferring federal and state income taxes.
Depreciation
An accounting method of allocating the cost of a tangible or physical asset over its useful life or life expectancy.
Modified Accelerated Cost Recovery System (MACRS)
The current tax depreciation system in the United States, allowing the capitalized cost of an asset to be recovered over a specified life through annual depreciation deductions.
Useful Life
The estimated duration an asset is expected to be functional and used for business purposes. Depreciation schedules are typically determined based on this factor.
Online Resources
- IRS: Depreciation Guidance
- National Apartment Association (NAA): Cost Segregation
- Real Estate Investment Management (REIM): Understanding Depreciation
References
- Internal Revenue Service (IRS). “Publication 946: How To Depreciate Property.” Updated Annually.
- Economic Recovery Tax Act of 1981.
Suggested Books for Further Study
- “The Real Estate Investor’s Guide to Cost Segregation” by Vernon Hovenbach
- “Advanced Tax Strategies for Real Estate” by Martin Zerbrow
