Understanding Depreciation In Commercial Real Estate

Commercial real estate investment is a great way to diversify your portfolio and take advantage of both residual income and speculation. There are so many dimensions to the process of purchasing commercial real estate property that it can be difficult to know what works for your situation and what doesn’t. 

We’ll dive in on what drives commercial real estate property values, and uncover more about commercial rental depreciation. 

Current Demand And Commercial Property Appreciation

An important question to consider is whether or not the annual transaction volume for that market has been increasing. If there is high demand for space to build (A.K.A. a high-appreciation area), properties are commonly held. This leads to increased market rents. Check out the current rents for an indication of the demand in your area of interest.

Also, rather than relying on the sales comparables or the replacement value of the building, an income approach might tell a better story on the building’s future value because it considers the amount of income it generates over time.

Another related factor is whether the infrastructure in place accommodates the current demand. If there isn’t any in place yet. How much is planned for future development?

Moving To And From Your Target Area

You’ll want to know if people are moving into the area and if they’ve been actively doing so for the last three years. The more people moving in, the better, but it’s also important to research why they’re moving there. 

Are there great local spots for food, drink and social time? Is the cost of living reasonable? What’s the weather like?

These factors all play a role in determining your market rates and the amount of depreciation you could have. 

Housing Projections In The Local Area

Look at the number of builder permits issued over the last 12 months. 

The more, the merrier in terms of commercial property valuation. Because new construction indicates high demand for the local area. 

Business Growth

An adage that holds true is that retail follows rooftops. If you have residential growth, you’ll have commercial growth. There needs to be a place for all the locals to shop, eat etc. 

Companies and franchises looking to jump in to the neighborhood bode well for your commercial real estate dynasty. There’s a lot to be said of commercial interest and the potential to rent space to these businesses. 

Commercial Real Estate Depreciation

Now that we understand the factors that contribute to appreciation, we can dive in on depreciation. 

Because commercial real estate is considered an asset rather than an expense, the Internal Revenue Service is strict on not permitting write-offs in the year you purchase it. Instead, the agency requires you to decrease its value every year by a small amount to simulate its gradual loss of value as the property deteriorates. This process is called depreciation. Most commercial buildings have a 39-year life, although you can speed up the process and claim your depreciation in less time. 

Commercial Buildings and Commercial Land

Commercial buildings are depreciated over 39 years. Commercial land is not depreciable, as the property isn’t developed and stands no chance to deteriorate. In this case the land has potential and can’t be depreciated. Land is usually included in the purchase of property so the value should be allocated accordingly.

It’s best to get an accountant’s advice on how to do this in a way that both maximizes your depreciation while also being able to pass further analysis with the IRS. If you make improvements to land so you can place a building on it, those improvements are depreciable over a time span of 15 years.

Cost Segregation And Commercial Depreciation

An effective way to accelerate your depreciation is through cost segregation. This allows you to divide your building into all of its constituent systems, some of which have a life that is much shorter than 30 years. 

If your building has a computerized security system, you could write off the computers in the security system over a five-year period. This moves some of your depreciation to the front of the depreciation schedule, earlier in your ownership of the building, and saves you money in the beginning. But by taking more depreciation up front, you have less depreciation to claim in the future.

Leasehold Improvements

When you build out space for a tenant, the IRS lets you depreciate those “leasehold improvements” over 15 years instead of 39 years. This is due to the fact that these improvements usually don’t last as long as the property. In order for the 15 year appreciation to apply, the improvements must be completely inside the tenant space and should be nonstructural. 

In addition to the accelerated 15-year depreciation, you can write off the entire balance of the leasehold improvements in one lump sum if the tenant moves out before the end of the 15 years. 

The 15-year timetable has been a part of the law since 2004 but requires periodic congressional approval.

Depreciation and Taxes

Depreciation offsets income from your rental property on a dollar-for-dollar basis. For example, if you have $100,000 of income and $30,000 in depreciation, your taxable income becomes $70,000. If you’re paying a 33 percent marginal tax rate, that would reduce your tax liability by $10,000. 

However, if you sell your building for more than its cost minus all the depreciation you claimed, the IRS will see that the building didn’t really lose value like it was supposed to based on your depreciation. In that instance, the agency would charge you a depreciation recapture tax, also known as a section 1250 tax, of 25 percent. Taking the above example, if you claimed $30,000 depreciation and the building that you bought for $1 million sold for $1 million, the IRS would charge $7,500 in depreciation recapture tax when you sell.

Types of Commercial Properties That Are Eligible For Depreciation

Offices, warehouses, retail locations, and other types of structures can be found on commercial sites. Knowing which kinds of business assets qualify for depreciation is crucial when it comes to tax benefits. In general, any commercial property used for business reasons that has a definite useful life of more than a year and is anticipated to lose worth over time is eligible for depreciation. This includes the physical framework of the building as well as any upgrades like landscaping, parking spaces, and signage. It’s crucial to remember that property cannot be depreciated because its worth does not diminish over time.

Your Next Commercial Real Estate Depreciation Schedule

Ready to purchase commercial real estate and take advantage of depreciation? Saint Investment will help. 

Whether you have a property in mind, or you’re looking to get started on your search, our investment specialists leverage extensive experience to bring you the best in commercial real estate depreciation expertise. 

Frequently Asked Questions:

What is depreciation in commercial real estate?

In commercial real estate, depreciation refers to the gradual decline in a property’s value due to wear and tear, obsolescence, or other causes. This accounting concept allows property owners to deduct a part of a property’s cost over a certain period of years for tax reasons.
Depreciation in commercial real estate may play a significant role in determining a property’s cash flow and return on investment.

How is depreciation calculated in commercial real estate?

Depreciation in commercial real estate is calculated using the Modified Accelerated Cost Recovery System (MACRS) established by the IRS. The cost basis of the property is divided into components, each with an assigned useful life, and a schedule provided by MACRS dictates the annual tax deduction based on the decline in value over time.

How does depreciation affect the value of a commercial property?

Depreciation reduces the tax basis of a commercial property over time, allowing the owner to claim yearly tax deductions. This can reduce the property’s taxable revenue, which can decrease the property’s total value. However, the property’s real market worth may not always decline owing to depreciation.

What are the benefits of depreciation in commercial real estate?

Depreciation in business real estate can lower a property owner’s taxable revenue, which lowers taxes. It can also increase cash flow by giving more funds for loan repayment or property reinvestment.

What are the limitations of depreciation in commercial real estate?

Commercial real estate depreciation is subject to recapture when the property is sold, reducing or eliminating the tax benefits. Additionally, certain property categories, such as land, do not qualify for depreciation.