Depreciation is a crucial component of commercial real estate investment. It is a tax deduction that allows investors to reduce their taxable income, and ultimately lower their tax liability. Depreciation is a non-cash expense that is based on the wear and tear of a property over time. While the property may still appreciate in value, the IRS allows investors to take a depreciation deduction each year to offset their taxable income.
In this article, we'll explore the benefits of depreciation in commercial real estate, how it works, and the different methods used to calculate it.
How does Depreciation work?
When an investor purchases a commercial property, they acquire an asset that has a finite lifespan. The property is subject to wear and tear over time, which reduces its value. Depreciation is the accounting method used to allocate the cost of the property over its useful life. This allows the investor to deduct a portion of the cost of the property each year from their taxable income.
The IRS has set guidelines on how long a commercial property can be depreciated. For most commercial real estate investments, the depreciation period is 39 years. However, there are some exceptions to this rule, such as residential rental properties, which have a depreciation period of 27.5 years.
Depreciation Benefits for Commercial Real Estate Investors
There are several benefits of depreciation for commercial real estate investors. Let's take a look at some of the most significant advantages:
Lower Tax Liability
Depreciation is a tax deduction that can significantly lower an investor's tax liability. By taking a depreciation deduction each year, investors can reduce their taxable income, which results in a lower tax bill.
Depreciation can improve cash flow for commercial real estate investors. By reducing taxable income, investors can increase their cash flow, which can be reinvested back into the property or used to acquire additional assets.
Increased Return on Investment (ROI)
Depreciation can increase the return on investment (ROI) for commercial real estate investors. By lowering their tax liability and increasing cash flow, investors can increase their ROI on the property.
Depreciation can help reduce risk for commercial real estate investors. By lowering their tax liability and increasing cash flow, investors can better weather economic downturns, vacancy periods, and other unexpected expenses.
There are two methods used to calculate depreciation for commercial real estate investments: straight-line depreciation and accelerated depreciation.
Straight-line depreciation is the simplest method used to calculate depreciation. It is calculated by dividing the cost of the property by its useful life. For example, if an investor purchases a commercial property for $1 million with a depreciation period of 39 years, the straight-line depreciation would be $25,641 per year ($1,000,000/39).
Accelerated depreciation allows investors to take a larger deduction in the earlier years of ownership. There are two main methods used for accelerated depreciation: the Modified Accelerated Cost Recovery System (MACRS) and the Section 179 deduction.
The MACRS method allows investors to depreciate commercial property over 39 years using a specific depreciation schedule set by the IRS. This method allows investors to take a larger deduction in the early years of ownership, which can improve cash flow and increase ROI.
The Section 179 deduction allows investors to deduct the full cost of the property in the year of purchase. This deduction is typically used for smaller commercial real estate investments, such as office equipment or vehicles.
Depreciation is a valuable tool for commercial real estate investors. It allows investors to reduce their tax liability, improve cash flow, increase ROI, and reduce risk. By understanding how depreciation works and the different methods used to calculate it.
Make the wise decision!
Commercial Real Estate Investor