Definition
Depreciation in the context of real estate appraisal is the measure of the reduction in the value of a property over time. This loss in value can be attributed to various factors including physical deterioration, functional obsolescence, or external obsolescence. Depreciation affects the market value and can significantly influence investment decisions and tax assessments.
Types of Depreciation
- Physical Deterioration: Wear and tear resulting from usage, weather conditions, and the passage of time.
- Functional Obsolescence: Irrational layout or design, outdated fixtures, or not complying with current standards.
- External (Economic) Obsolescence: Factors outside the property impacting its value, such as changes in the neighborhood or economy.
Examples
Example 1:
A commercial building is 20 years old and has experienced considerable wear and tear. Physical deterioration, like a leaking roof and outdated HVAC system, leads to a reduction in property value.
Example 2:
A residential property has a kitchen and bathrooms that haven’t been renovated in 30 years, making it less appealing to potential buyers, thus demonstrating functional obsolescence.
Example 3:
A property located next to a newly constructed noisy highway suffers from a decrease in value due to external obsolescence.
Frequently Asked Questions
What is the significance of depreciation in real estate appraisal?
Depreciation reduces a property’s value, impacting its market value and investment potential. It also affects tax assessments and insurance valuations.
Can land depreciate?
No, land itself does not depreciate as it does not generally wear out or become obsolete.
How is depreciation calculated?
Depreciation in real estate appraisal is often calculated using methods like straight-line depreciation, declining balance, or units of production, factoring in the type and extent of wear and obsolescence.
Does depreciation affect tax assessments?
Yes, depreciation is considered in tax assessments, as it can affect the taxable value of the property, potentially reducing property taxes for owners.
Can depreciation be reversed?
Functional obsolescence may sometimes be reversed through renovations and upgrades, while physical deterioration can be mitigated with maintenance. However, external obsolescence is typically out of an owner’s control.
Assessed Value
The dollar value assigned to a property by a public tax assessor for taxation purposes.
Market Value
The price a willing buyer would pay to a willing seller in an open and competitive market.
Capitalization Rate (Cap Rate)
A rate used to convert an income stream into a value estimate for income-producing properties.
Replacement Cost
The cost to replace or repair property with materials of similar kind or quality at current prices and methods.
Useful Life
The period during which a property can be expected to remain useful for its intended purpose.
Online Resources
References
- Geltner, D., Miller, N.G., Clayton, J., & Eichholtz, P. (2013). Commercial Real Estate Analysis and Investments. OnCourse Learning.
- Brueggeman, W.B., & Fisher, J.D. (2010). Real Estate Finance and Investments. McGraw-Hill/Irwin.
- Fanning, S. (2014). Market Analysis for Real Estate: Concepts and Applications in Valuation and Highest and Best Use (Second Edition). Appraisal Institute.
Suggested Books for Further Study
- John A. Yoegel, “Real Estate License Exams For Dummies”
- David C. Ling and Wayne R. Archer’s “Real Estate Principles: A Value Approach”
- William L. Ventolo Jr. and Martha R. Williams, “Fundamentals of Real Estate Appraisal”
- Charles J. Jacobus, “Real Estate Principles”
Real Estate Basics: Depreciation (Appraisal) Fundamentals Quiz
### Does depreciation apply to both the building and the land it is on?
- [ ] Yes, both the building and the land can be depreciated.
- [x] No, only the building can be depreciated.
- [ ] Depreciation does not apply to real estate at all.
- [ ] Both the building and land depreciate equally.
> **Explanation:** Depreciation only applies to the building itself and not the land it is located on. Land typically does not lose value over time, whereas buildings do due to wear and tear.
### Over how many years must residential property be depreciated according to tax laws?
- [x] 27.5 years
- [ ] 15 years
- [ ] 30 years
- [ ] 39 years
> **Explanation:** According to tax laws, residential properties must be depreciated over a 27.5-year term. This allows for an annual deduction related to the depreciation.
### Over how many years must commercial property be depreciated according to tax laws?
- [ ] 27.5 years
- [ ] 30 years
- [x] 39 years
- [ ] 45 years
> **Explanation:** According to tax laws, commercial properties must be depreciated over a 39-year term. This extended period helps distribute the depreciation deduction over a longer time frame.
### Which type of property allows for depreciation as an income tax deduction?
- [ ] Personal-use property
- [ ] Land
- [x] Income-producing property
- [ ] All types of property
> **Explanation:** Depreciation can be used as an income tax deduction for businesses for properties that are used for income-producing activities. Properties used for personal purposes do not qualify for depreciation deductions.
### What must a property have for it to qualify for depreciation?
- [x] A useful life of at least one year
- [ ] A mortgage attached to it
- [ ] An appraisal conducted every three years
- [ ] Equal use between personal and business
> **Explanation:** To qualify for depreciation, the property must have a continued useful life of at least one year and must be used for an income-producing activity.
### Who provides the allowance for the normal wear and tear of a piece of property?
- [ ] Real estate agents
- [ ] Local municipalities
- [ ] Property management companies
- [x] The Internal Revenue Service (IRS)
> **Explanation:** The Internal Revenue Service (IRS) provides an allowance for the normal wear and tear of a piece of property, which can be deducted from taxable income through depreciation.
### When filing an annual tax report, who can claim depreciation?
- [ ] Any resident of the United States
- [ ] Any homeowner regardless of purpose
- [x] Individuals or businesses that own income-producing property
- [ ] Only those with newly built properties
> **Explanation:** Only individuals or businesses that own income-producing property and meet other specified criteria can claim depreciation when filing an annual tax report with the IRS.
### Depreciation is used to offset which type of expense for businesses?
- [x] Income tax liability
- [ ] Mortgage interest
- [ ] Utility expenses
- [ ] Insurance premiums
> **Explanation:** Depreciation can be used as an income tax deduction, effectively reducing the income tax liability of a business.
### Why is depreciation especially important for businesses?
- [ ] It is a source of immediate revenue.
- [ ] It increases the value of properties.
- [x] It allows for a significant tax deduction over time.
- [ ] It avoids the need for any property-related expenses.
> **Explanation:** Depreciation is important for businesses as it allows for a significant tax deduction over time. This tax benefit can improve the financial condition of the business by reducing tax liabilities.
### What aspect of a property predominantly affects its depreciation schedule?
- [x] Whether it is residential or commercial
- [ ] The construction material used
- [ ] The color of the building
- [ ] The landscape quality
> **Explanation:** The depreciation schedule is predominantly affected by whether the property is residential or commercial, with residential properties having a 27.5-year term and commercial properties having a 39-year term.
