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Real Estate Depreciation

Depreciation is a loss in the value of an asset over time. The Federal tax code allows owners to take a deduction for depreciation on assets used for business purposes (like real estate investment property) each year to offset investment income and/or ordinary income. Depreciation can be taken for buildings, machinery, appliances, furniture, fixtures, cars, computers, anything with a useful lifespan of over 1 year, that does not last indefinitely, and is used for business.

Everything ages over time from wear and tear and frequent use; there is a corresponding drop in asset value the more the asset is used. Eventually, the asset wears out and reaches the end of its useful life and needs to be replaced. Depreciation is a theoretical tax method the Government uses to account for an asset’s loss in value. It is important to note that Depreciation is a theoretical tax method and not an actual appraisal of value. For tax purposes, the value of real estate at the end of its depreciable life of 27.5 years (Residential) or 39 years (Commercial), is zero or no value, while in reality, houses, duplexes, and apartment buildings last longer than that and still have actual value.

It is important to note, Depreciation is a deferral of tax, not forgiveness. Some Investors who are selling their first investment property are surprised by a larger than expected tax liability for a sale. Everyone always remembers Capital Gains Tax, but the first time investment seller often forgets to consider Depreciation Recapture Tax (see below) also.

One other general note I’d like to make about Depreciation is that whether you use it or not on your annual income tax filings when you sell, the government assumes you took depreciation- so you still have to pay depreciation recapture tax! So if you own an investment property, make sure you are taking your depreciation each year. If you don’t use it you lose it.

Investors love depreciation because it is one of the X benefits of owning real estate and provides hefty tax deduction which increases the investment property’s after-tax cash flow or provides a tax shelter for the owner’s personal income.

I recommend talking with an accountant about Depreciation. Need a Los Angeles real estate accountant referral? Let me know and I am happy to provide one.

For more Depreciation information, See IRS Publication 946.

How Depreciation Works

Land cannot be depreciated.

Land is indestructible and never gets used up so it is exempt from Depreciation. The only thing that is depreciable is the structure value.

This presents a challenge for property owners and tax professionals who want to determine the ratio of Land Value vs Structure Value for a property that’s purchase price included both costs.

Calculating Land Value vs Structure Value Ratio

Talking with several accountants there is no hard and fast rule of thumb for determining the ratio of land to structure value. The answer is – it depends. There are a bunch of different kinds of properties out there (oil pipelines, nuclear power plants, warehouses, retail stores, single-family houses, hotels etc) so you have to look at each property on a case by case basis.

To start- I like to look at the total amount of SQFT for structure and land, the more sqft of land the higher percent I’d expect for land value and the more sqft for structure the higher percentage I’d expect for Structure.

In some cases, it can be very easy to calculate the ratio. Vacant land is 100% land value. Mobile Homes are 100% structure. Condos are usually about 90% structure value (10% is common area interests in the land of the common areas). Suppose you are building new construction from the ground up- You can just depreciate your build cost.

However, for cases of buying an existing property, where the price includes the structure and the land it can get more complicated.

The More Structure the better for Depreciation

Investors have a vested interest in having the structure value be as large as possible to maximize the amount of Depreciation they can take. What ratio you choose to apply will depend on how aggressive or conservative you are financially or the advice you receive from your accountant.

For the majority of properties I see in LA I would expect at a minimum of 50% structure value ratio. The structure value can go as high as 80% in some cases, for single-family homes and apartments, but if there is a normal size (5,000 sqft) lot or larger I do not see any arguments for more than this. 50/50 structure to land and 60/40 structure to land are pretty conservative ratios. 70/30 structure to land and 80/20 structure to land are starting to push it.

IRS Publication 527 is the only place I can find any mention of this in the tax code. It says:

If you are not certain of the values, you are allowed to use the tax assessors ratios to determine your depreciation. You can look up your tax assessor value here assessed value on the tax rolls.

To be honest, I have found the Los Angeles assessor records way off for land value vs structure value. They routine show less than 50/50 for structure value to land value. You don’t need to be that conservative. One of the issues I find is that the redevelopment potential is so much larger than the as built structure that you can get some pretty funky valuations. It is no secret that todays buyers want bigger houses. Before the 1960s which is when most of Los Angeles was built out, most of the homes built were single story 1500 sqft 3br / 2 ba homes built on 6,500 sqft lots. With the current building code you can build up to 4,000 sqft on that same lot. The Value of that 3br 1500 home on the westside currently is $1,500,000 to $1,600,000. The development potential of the lot could make a new construction house worth $4,500,000. As a result in the eyes of a builder that $1.6M is 100% land value, and they are willing to spend another $1M – $1.5M to build the bigger home. For a buyer who just wants to buy the home and live in it, the structure has value to them, and they aren’t coming with all the additional money to improve the lot. I find the assessor has a land bias to development potential on their assessor rolls which isn’t fair to regular folks.

Example

1265 S Tremaine Ave

1265 S Tremaine Ave is a duplex that was listed for sale for $990,000. How much of the value is land vs structure according the assessor?

Assessor Information

The Assessor shows that the current tax roll values are $249,622 for Land and $137,289 for improvements.  $249,622 Land + $137,289 Improvements = $386,911 Total Assessed Value. Take the Improvement divided by Total value to get the ratio. $137,622 Structure/$386,911 assessed value = 35.5% building to land ratio. Take the new purchase price $990,000 * .355 =  $352,137 value of Structure for depreciation. Again, I would use at least 50%- not a big fan of using the assessor rolls to calculate depreciation.

Depreciation Method – MACRS – GDS

Modified Accelerated Cost Recovery System (MACRS) is the standard method used for depreciation of investment real estate put into service after 1986. There are two different systems for MACRS, the General Depreciation System (GDS) and Alternative Depreciation System (ADS). You will be using GDS for investment property you own in the US. The Depreciation recovery periods are longer for ADS which is why you don’t want to use it. The recovery period for residential real estate under ADS is 40 years! As opposed to 27.5 years with GDS.

Real Estate Depreciation is calculated with the straight line method

All Real Estate depreciation must be calculated by the Straight Line Method (it is very easy). Personal Property has 150% and 200% declining Balance options for depreciation methods.

Straight-line Depreciation Equation
Made up Graph of straight-line depreciation, you deduct the same amount each year until there is zero basis.

I like this online depreciation calculator:  click here.

GDS assigns Recovery periods for different assets:

MACRS GDS property classes

Property ClassPersonal Property (all property except real-estate)
3-year propertyTractors
Race Horses
Special handling devices for food and beverage manufacture
Special tools for the manufacture of finished plastic products, fabricated metal products, and motor vehicles
5-year propertyAutomobiles, taxis, buses, trucks.
Computers
Office Machinery
Cattle
Appliances, carpets, furniture (residential real estate use)
Airplanes
Petroleum drilling equipment
Certain geothermal, solar, and wind energy properties.
7-year propertyOffice furniture, fixtures, and equipment (such as desks, files, and safes)
Manufacturing Machinery and equipment (agriculture, mining, weaving, tobacco etc)
10-year propertyBoats, Barges, Tugs, and water transportation Equipment
Trees and vines that bear fruit
15-year propertyImprovements to Land (landscaping, fences, roads, sidewalks, bridges)
Cement
Wharves and Docks
Restaurants
Gas Stations
Telephone Communications
Municipal sewage treatment plants
Oil and Gas Pipelines
Nuclear Power plant
20-year propertyFarm Buildings
Railroad Structures
Utility Service (Electric, Water, Gas)
Municipal sewers
Property ClassReal Property (real estate)
27.5-year propertyResidential rental property (does not include hotels and motels)
39-year propertyNon-residential real property
This article is focused on real estate, so I won’t be going into how depreciating personal property works but its different. The most common personal property you run into is the Automobile that can be depreciated over 5 years. The MACRS system does not use Salvage value, although older depreciation systems used by the IRS did- if you are wondering the salvage value for real estate is zero.

Residential Real Estate has a shorter Depreciation timeline than Commercial Property.

Residential PropertyCommercial Property
27.5 Years39 Years
Example Residential: You purchased a $500,000 Duplex in 2009, that had land value of $200,000 and a structure value of $300,000- how much depreciation can you deduct?

$300,000 structure value/ 27.5 years = $10,909 depreciation per year.

Example Commercial: You purchased a $500,000 5 Unit apartment building in 2009, that has a land value of $200,000 and a structure value of $300,000- how much depreciation can you deduct?

$300,000 structure value/ 39 years = $7,692 per year

What is the definition of Residential Property?

According to Internal Revenue Code §168(e)(2)(A)(i), “residential rental property” means any building or structure that 80 percent or more of the gross rental income is from residential dwelling units.  A 10-unit apartment building is residential for depreciation purposes even though it is considered commercial for lending purposes.

 How Do Improvements to Property Work for Deprecation?

Let’s suppose that in the example above with the duplex after five years of owning it- in 2014, you decided to build a 3rd unit on the property over the garage. The unit cost you $150,000 to build. Can you Depreciate it? Of course! Additions and New Construction is treated as Real Property and has either a 27.5 year schedule for residential and 39 year schedule for commercial. In 2014 when you build the extra unit the $150,000 of construction cost gets added to your basis. Here is a table of the deduction schedule:

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