Depreciation (Tax)

Definition

Depreciation (Tax) is an essential concept in real estate accounting, providing an annual tax deduction to account for wear and tear, deterioration, or obsolescence of property. This deduction signifies a loss in the asset’s utility and is designed to reflect the decreasing value of improvements (buildings, structures) over the life of the property. Land itself is excluded from depreciation. Notably, depreciation benefits real estate investors by allowing them to deduct a portion of the property’s cost from their taxable income.

Examples

Residential Property: A real estate investor who owns a rental property can depreciate the building over 27.5 years. If the property’s improvement cost is $275,000, the annual depreciation deduction will be $10,000 (3.64% of the property’s cost).
Commercial Property: An owner of a commercial building purchased for $390,000 can depreciate the property over 39 years. The annual depreciation for the building’s improvement would be approximately $10,000 (2.56% of the property’s cost).

Frequently Asked Questions (FAQ)

Q1: What kinds of property can be depreciated?
A1: Properties used for income-producing and business purposes can be depreciated. This includes residential rental properties, commercial buildings, and other income-generating real estate.

Q2: Can land be depreciated?
A2: No, land cannot be depreciated as it does not wear out or become obsolete over time.

Q3: How does depreciation benefit real estate investors?
A3: Depreciation provides a tax deduction without requiring an actual cash outlay, effectively lowering taxable income and thereby reducing tax liability.

Q4: What happens if the property’s market value increases?
A4: Depreciation can still be claimed even if the market value of the property increases. The deduction is based on the initial cost of the improvements, not the current market value.

Q5: What is depreciation recapture?
A5: Depreciation recapture is a tax provision that recovers the tax benefit of depreciation when the property is sold for a profit. It is taxed at a higher rate than long-term capital gains.

Accelerated Depreciation: Depreciation methods that allow higher deductions in the early years of an asset’s life.
Modified Accelerated Cost Recovery System (MACRS): The current tax depreciation system in the United States that accelerates depreciation for tax purposes.
Declining Balance Depreciation: A depreciation method in which an asset’s book value is reduced at a constant percentage rate over its useful life.
Depreciable Real Estate (Tax): Properties that qualify for tax depreciation due to their use in business or income production.
Depreciable Basis: The amount of the property’s cost that can be depreciated over its useful life.
Useful Life: The expected period during which an asset is usable for its intended purpose.

Online Resources

References

IRS Publication 946: How to Depreciate Property. Internal Revenue Service.
“Depreciation.” Investopedia.
“Depreciation Recapture.” National Association of Real Estate Investment Trusts (NAREIT).

Suggested Books for Further Studies

“Real Estate Accounting Made Easy” by Obioma A. Ebisike
A comprehensive guide that simplifies real estate accounting principles including depreciation.
“Principles of Real Estate Practice” by Stephen Mettling
A leading real estate education textbook that covers foundational concepts including depreciation.
“Tax-Free Wealth” by Tom Wheelwright
This book provides in-depth strategies for using tax-saving tools like depreciation to build wealth.

Real Estate Basics: Depreciation (Tax) 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.