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.
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.
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?
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.
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.
I like this online depreciation calculator: click here.
GDS assigns Recovery periods for different assets:
MACRS GDS property classes
|Property Class||Personal Property (all property except real-estate)|
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 property||Automobiles, taxis, buses, trucks.|
Appliances, carpets, furniture (residential real estate use)
Petroleum drilling equipment
Certain geothermal, solar, and wind energy properties.
|7-year property||Office furniture, fixtures, and equipment (such as desks, files, and safes)|
Manufacturing Machinery and equipment (agriculture, mining, weaving, tobacco etc)
|10-year property||Boats, Barges, Tugs, and water transportation Equipment|
Trees and vines that bear fruit
|15-year property||Improvements to Land (landscaping, fences, roads, sidewalks, bridges)|
Wharves and Docks
Municipal sewage treatment plants
Oil and Gas Pipelines
Nuclear Power plant
|20-year property||Farm Buildings|
Utility Service (Electric, Water, Gas)
|Property Class||Real Property (real estate)|
|27.5-year property||Residential rental property (does not include hotels and motels)|
|39-year property||Non-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 Property||Commercial Property|
|27.5 Years||39 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:
|Year||Book Value||Depreciation||Accumulated Deprecation||Book Value End|
|2014 (150K improvement)||$395,910||$16,136||$70,244||$379,774|
|2036 (original structure fully deducted)||$36,151||$11,363||$425,230||$24,785|
Depreciation lowers your property’s tax basis.
If you claim depreciation on real estate, that property is considered 1250 property for federal tax purposes. When you sell 1250 property- if the property has a gain over its adjusted basis, the proceeds go in two separate buckets, you must pay Depreciation Recapture tax for the first bucket- and any gain beyond depreciation recapture is a capital gain and subject to capital gains tax and goes in the capital gains tax bucket, unless you defer both taxes with a 1031 Exchange.
The government allows you to reduce the asset value to zero with depreciation, but if you sell the property for more than its basis, this tells the government that it in fact, the building is not worthless, and they want to collect the “back taxes” on the ordinary income you offset over the years Depreciating with Depreciation Recapture.
The Tax rate for Depreciation recapture is 25%, which is slightly higher than the maximum capital gains tax currently of 20%, but probably still a lot lower than what you would have paid in ordinary income tax.
Let’s say an investor bought a rental property a few years ago for $100,000 and took $20,000 in depreciation.
Example 1. LossAssume the property sells for $70,000. The Adjusted basis in the property is $80,000 so this sale results in a loss and no tax is due. Depreciation Capture doesn’t carry over to a new property or follow the taxpayer. The depreciation capture tax liability is lifted once you sell the property.
Example 2. Just Enough Gain for Depreciation to be recaptured
Assume the property sells for $100,000. This is the same price as you bought it for several years ago, except now, the government views this sale as a gain of $20,000! You have to pay Depreciation recapture tax on the gain which is 25% or $5,000
Example 3. Gain large enough for depreciation capture + Capital gain
Assume the property sells for $150,000. Now you have $70,000 gain over your adjusted basis. $20,000 of the gain will be taxed at Depreciation Recapture rate of 25% ($5,000), and the remaining $50,000 gain will be taxed at Long Term Capital Gains tax rate, for this example, let’s say 20% ($10,000).
California State Depreciation Taxes
California doesn’t have any special tax rates for Capital Gains tax or Depreciation Recapture. On your California tax return, Depreciation Recapture and Capital gains are taxed like any other income at your state rate.
For very Large Commercial Properties, a Cost Segregation (“cost seg”) analysis may grant higher annual deductions.
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Can I depreciation my primary residence?
No, Depreciation is only for investment real estate.
I own a 2-4 unit residential income property and I live in one of the units, can I depreciate it still?
Yes, you are allowed to depreciate the percentage of the building being used for investment purposes. For example, with a side by side duplex, that are equally sized units, 50% of the structure would be depreciable. In 3 unit with equal size units 66%, and for 4 unit 75%.
I own a 5U Commercial Income Property- do I Depreciate on 27.5 years schedule for residential or 39 years for commercial?
According to the IRS rule if 80% or more of a building’s rental income comes from renting residential units than for Depreciation purposes it is considered residential and would be depreciated on 27.5 schedule.