Calculating Depreciation

First of all, depreciation is mandatory. You must accept and claim depreciation deductions if your property qualifies for depreciation . You cannot elect out of it. [Consequently, real estate investors cannot file 1040EZ short forms.] You may wonder why someone would forego depreciation deductions; there are investors with sufficient deductions elsewhere and don't need any more deductions. Moreover, depreciation tends to be considered passive activity losses; so they cannot be easily deducted against ordinary or portfolio income.

The IRS has established fairly clear tables for determining depreciation deductions on investment real estate. Real property depreciation can be simplified into two groups:

  1. After 1987
  2. Before 1987

After 1987

Investment real estate that the taxpayer has purchased and placed into service after January 1

1987, uses the Modified Accelerated Cost Recovery System (MACRS) to calculate depreciation . Note that this date is based on the taxpayer's action. The key date is not when the property was originally built and placed into service, but when the current taxpayer bought the property and placed it into service as a business, trade or rental property.

Real estate investors are most often concerned with the following MACRS tables:

  1. Residential rental property—27.5 years
  2. Commercial real estate—39 years
  3. Building components

Residential rental property

Residential real estate that is held for rent and income-production is depreciated over 27.5 years. Such properties include apartment buildings, condominium units, cooperative units, duplexes and houses rented as residences for tenants.

However, the IRS specifically excludes hotels, resorts and motels from this category. Those "transient" properties are considered commercial real estate.

Mixed-use properties, which contain both residential and commercial units, are not prorated. The entire real estate property must be categorized as either residential or commercial. To qualify for the more beneficial residential category, the mixed-use building must receive at least 80% of its gross rental income from the residential dwelling units.

For example, Nasser owns a mixed-use building that contains three offices on the first floor and three apartment units on the upper floors. Although the unit breakdown is 5050, Nasser actually receives $4,200 per month from his residential tenants and only $1,000 per month for the office spaces. Because the residential income accounts for more than 80% of the gross rental income, this property can be classified as residential, with regard to depreciation deductions.

To calculate the depreciation deduction for residential real estate, you must first determine your unadjusted "depreciable" basis. The depreciable basis is normally the purchase price, less the value of the land (which cannot be depreciated). After determining your depreciable basis, you can use the following MACRS table to determine the factor by which you must multiply that depreciable basis.

Note that your factor will vary according to the tax year you are currently in, with regards to the subject property, and the month of the year in which the property was acquired and placed into service:

Years

Jan

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

1

3.485

3.182

2.879

2.576

2.273

1.970

1.667

1.364

1.061

0.758

0.455

0.152

2-9

3.636

3.636

3.636

3.636

3.636

3.636

3.636

3.636

3.636

3.636

3.636

3.636

10, 12, 14, 16, 18, 20, 22, 24, 26

3.637

3.637

3.637

3.637

3.637

3.637

3.636

3.636

3.636

3.636

3.636

3.636

3.636

3.636

3.636

3.636

3.636

3.636

3.637

3.637

3.637

3.637

3.637

3.637

1.970

2.273

2.576

2.879

3.182

3.485

3.636

3.636

3.636

3.636

3.636

3.636

0.000

0.000

0.000

0.000

0.000

0.000

0.152

0.455

0.758

1.061

1.061

1.667

For example, Gene buys an apartment building for $1.2 million. The land is worth about $200,000, so his depreciable basis is $1 million. Gene bought and purchased the property in May 2001. His annual depreciation deductions for the first year would be as follows:

  1. First year: (1 May factor) 2.273% x $1,000,000 = $22,730
  2. Second year: (2 May factor) 3.636% x $1,000,000 = $36,360
  3. Third year: (3 May factor) 3.637% x $1,000,000 =$36,370

Gene can therefore deduct up to $22,730 in depreciation deductions against the property's income. If the property generates a passive activity loss, that loss can then be deducted against other passive activity income. As will be discussed in the "Passive Activity Deductions" section, a net passive activity loss that arises from real estate investments can sometimes be deducted from ordinary and portfolio income to lower the investor's taxable income.

You may notice that all of the even-numbered years between year 10 and year 26 (i.e. 10, 12, 14, etc.) all have the same depreciation percentage rates; while all of the odd-numbered years between years 11 and 27 (i.e. 11, 13, 15, etc.) all share the same depreciation rates. Also, the depreciation percentage rates for years 2 through 9 are all the same.

Commercial real estate

Depreciation for commercial properties is on a more extended basis of 39 years. However, commercial properties that were acquired before May 13, 1993, but after 1986, use a 31.5-year depreciation table.

Commercial real estate includes office and retail properties, as well as some industrial facilities and mixed-use residential properties.

The 39-year deprciation table for commercial real estate purchased after May 13, 1993, is as follows:

Years Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov

1 2.461 2.247 2.033 1.819 1.605 1.391 1.177 0.963 0.749 0.535 0.321 0.107

2-39 2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564 2.564

40 0.107 0.321 0.535 0.749 0.963 1.177 1.391 1.605 1.819 2.033 2.247 2.461

As noted above, commercial properties acquired between 1987 and 1993 use the 31.5-year table. A copy of that table and all depreciation tables are available from www.IRS.gov.

Building components

The IRS also maintains MACRS tables for a variety of other assets and equipments, which tend to have shorter useful lives than real estate improvements. Unfortunately for real estate investors, components that are structural to the building and/or fixtures are categorized as real property and are depreciated over the useful life of the building-27.5, 31.5 or 39 years.

This is a disadvantage for real estate investors, because even though a hot water tank may have a useful life of 10 years, it must be depreciated for 27.5 to 39 years.

But wait...it gets even worse for components that are added to the building. For example, if you need to replace the furnace in your office buildings five years after you bought the property, you must depreciate that new furnace over 39 years; and you must start on the date it was purchased and installed.

Furniture, equipment and other assets that the real estate investor acquires are depreciated over a shorter time frame. The following are a few personal property depreciation classes:

  • Construction equipment. Most construction equipment and tools are depreciable over five (5) years.
  • Improvements to land. Sidewalks, driveways, sewers, landscaping, drains, docks, canals and other similar non-building improvements to land are normally depreciable over fifteen (15) years.
  • Electronic office machines. Typewriters, copiers, computers, printers and fax machines are normally depreciable over five (5) years. Other office furniture, fixtures and equipment are depreciable over seven (7) years.
  • Residential unit furnishings. Apartment furniture, stoves, microwave ovens, conventional ovens, trash disposals and refrigerators are depreciable over five (5) years.
  • Agricultural. General farm buildings are usually depreciable over twenty (20) years, although special-use structures such as silos and bins are depreciable over a shorter span of ten (10) years. Farming machinery and other agricultural equipment are usually depreciable over seven (7) years.

Note that savvy investors can use these different classes to improve their depreciation situation. For example, if you buy an office building or farm, you can shorten your depreciation period by separating certain equipment, land improvements and farm components.

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Responses

  • raimo
    How can I calculate depreciation on a mixed use residential/commercial building?
    7 years ago
  • arcangelo lo duca
    Is a 10 unit apartment depreciated over 27.5 or 39 years?
    7 years ago
  • Minnie
    Is a resort depreciated 27.5 or 39 year?
    7 years ago
  • lelio
    How to depreciation mix property commercial and residential?
    7 years ago
  • andwise
    Which of the following is NOT included when calculating the depreciable basis for real property?
    2 years ago
  • grimalda
    How to depreciate a mixed commercial and residential property?
    7 months ago
  • geraldino
    How to depreciate a mixed use building?
    2 days ago

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