This article covers the use of depreciation allowances for tax reporting by owners of improved real estate, and the recapture profit tax on a sale for depreciation deductions taken during ownership.
Cost recovery for improved real estate
Owners of improved real estate annually recover, tax-free, a portion of the property’s acquisition cost from income generated by rents or the owner’s use of the property in his trade or business. This is called a depreciation deduction, return of capital or capital recovery.
The capital recovery provided by the depreciation deduction serves several investment and tax purposes for owners of both personal property and real estate. Depreciation, as defined, focuses on investment and tax purposes. The attitude of investors is that depreciation, contrary to definition, is tax-free “spendable income,” not capital, since price inflation and value appreciation commonly offset the rate of physical depreciation and increase the dollar value of the property beyond its acquisition price.
A common dictionary defines depreciation as “a decrease in value of property through wear, deterioration or obsolescence.”
Black’s Law Dictionary defines depreciation as “a decline in value of property caused by wear or obsolescence and is usually measured by a set formula which reflects these elements over a given period of useful life of the property.”
The Internal Revenue Service (IRS) defines a depreciation deduction as a reasonable annual allowance for the exhaustion, wear and tear, and obsolescence of property. [Internal Revenue Code §167(a)]
Thus, depreciation is intended to reflect a value-related loss in property due to use, decay and improvements that have become outdated.
The rationale for depreciation deductions is to allow the cost of any improvements to be written off over the period of their useful life.
Personal property used in a business opportunity or rental property best manifests the actual wear, deterioration and obsolescence which cause a nominal dollar decline in the property’s value over a short period of time.
In contrast, the value of improved real estate is usually managed and maintained by incurring expenses to eliminate any wear, decay or obsolescence which, if not corrected, would contribute to a decline in the property’s dollar value.
Thus, in contrast to the defined purpose of depreciation deductions, properly maintained rental real estate is considered appreciable property by investors. Over time, real estate values tend to be a hedge against price inflation. Conversely, personal property is often referred to by investors as a depreciable or wasting asset.
Investors’ view of depreciation
Real estate investors have given the word “depreciation” an entirely different meaning than as defined. For investors, depreciation is related to “freeing up” the investment made to acquire the property, not to the tax-free recovery of loss of property value.
The IRS, in essence, effectively gives the investor an annual tax-free return of invested capital (acquisition costs) on real estate improvements while at the same time allowing the deduction of expenses for maintenance which increases the property’s actual (nominal) dollar value. The increasing dollar value of the property often surpasses even the rate of inflation during the depreciation period. Any increase in value over annual inflation is commonly referred to as appreciation since this increase in value is usually a product of demographics, such as population density.
The rationale for depreciation deductions during the ownership of real estate is to allow the cost of any improvements, whether paid for in cash or financed by a long-term mortgage, to be entirely “written off” over the period of their “useful life.” No salvage value of the improvements remains at the end of the depreciation period. [IRC §168(i)(8)(A)]
A tax incentive for owners of improved real estate rented to others or used in the owner’s trade or business is the greater dollar value the property will likely have over its original cost after all capital invested in the improvements has been recovered tax-free from rental or business income. However, on a sale, the depreciation taken during ownership is taxed at a 25% rate, a type of profit called unrecaptured gain. [IRC §§1(h)(1)(D); 1250(c)]
Simply put, depreciation deductions from rental income to recover the cost of acquiring a property are allowed over a fixed period of time – 27.5 years to 40 years. The deductions are calculated from the mid-month of the month of acquisition for all rental property, improved investment property and improved property used in the owner’s business. [IRC §168(d)(2)]
A return of capital from income
As viewed by prudent investors, the rental income remaining after deducting operating expenses includes both:
- a return of invested capital; and
- a return on invested capital.
|The depreciation allowance is an orderly return of capital invested from funds used to acquire or improve property.||Thus, the total of both types of returns (of and on the investment) is represented by the property’s net operating income (NOI). The payment of interest out of the NOI is merely a payment of a portion (or all) of the return on invested capital since purchase-assist financing provided the capital needed to acquire the property.|
Depreciation is the title the IRS gives to the investor’s return of capital. Depreciation is deducted from a rental’s NOI and constitutes a return of capital by the straight-line depreciation allowance over a fixed period of time (27.5, 39 or 40 years).
Net operating income (NOI) from highly leveraged (mortgaged) acquisitions is often insufficient to actually reimburse the owner for his annual depreciation allowance by producing spendable income. Insufficient rental income (or excessive operating expenses or interest carrying costs) together with the depreciation deduction causes the investment to produce a reportable loss for the year’s operations.
Conversely, rental income remaining after payment of operating expenses and loan interest deductions is the source of the tax-free return of invested capital. The tax-free return is reflected first in loan principal reduction and then in any spendable income or the construction cost of any further improvements paid for out of rents.
Erroneously, depreciation is said to “shelter” loan reductions and spendable income from taxes. However, depreciation does not shelter income at all. The depreciation allowance is an orderly return of capital invested from the owner’s funds and any funds borrowed to acquire or improve the property – funds which are capital contributions to the property’s cost basis.
However, repairs and replacements made to maintain the improvements are expensed, not deducted from NOI as is depreciation and interest. Ironically, both maintenance expenses and depreciation deductions are allowed for the same reasons: obsolescence and deterioration of the property.
On one hand, the owner is recovering his original investment (cash and loan amounts) by way of a depreciation deduction from rental income. On the other hand, expenditures made by the owner for repairs and replacements maintain (and often increase) the property’s value and are written off as allowable expenses. Thus, maintenance expenses eliminate the effects of wear, deterioration and functional obsolescence which are the very basis for allowing the depreciation deduction – a double dipping, if you wish, enjoyed by real estate investors.
Basis for each property
A cost basis must be established on the purchase of a property before the depreciation of its improvements will be allowed as a deduction. The cost basis in a property acquired consists of, among other things, all costs of acquisition and capital improvements to the property. [IRC §1012]
A property’s cost basis comprises:
- all loan funds used and carryback notes given to purchase or improve the property, whether or not secured by the property;
- any cash the buyer contributed toward the purchase price or cost of improvements; and
- the value of any property contributed toward the purchase or improvements, except for any profit realized on the contribution of an equity in property classified as like-kind IRC §1031 property (in which case, the remaining cost basis is carried forward to become part of the cost basis of the replacement property).
Land and improvement allocation
Only the cost of depreciable improvements is recovered through depreciation schedules. The cost of acquisition of the land is not depreciable.
The purchase of a fee ownership interest in a parcel of improved real estate includes both land and buildings.
Thus, of the total cost of land and improvements, only the share of the costs attributable to the improvements may be deducted under depreciation schedules. [Revenue Regulations §1.167(a)-5]
In the case of resident farmers, the share of the farm’s cost allocated to a farmhouse occupied by the owner cannot be depreciated. The cost of acquisition allocated to the farmhouse which is the owner’s residence receives the same non-depreciable treatment given the cost of land. [Rev. Regs. §1.167(a)-6(b)]
|Instead of acquiring a fee ownership interest in real estate, a leasehold ownership interest may be acquired. Ground leases are often purchased at considerable cost to the tenant. Frequently, additional improvements are constructed by the tenant on the property leased.||
The cost of acquisition of land is not depreciable under depreciation schedules.
Taxwise, the value of the land is not considered to have been purchased when a ground lease is acquired by a tenant.
Editor’s note – This is not true under California landlord/tenant law – the leasehold ownership includes both the described land and the improvements located on it.
Thus, the tenant’s entire cost of acquiring the ground lease, plus his cost to construct any leasehold improvements, is depreciable under the residential or nonresidential schedules (27.5, 39 and 40 years).
Property improvements are depreciated by the fee owner or leasehold owner (tenant) according to the schedules applicable to the type of property on which the improvements exist. [IRC §168(i)(6)(A)]
Depreciation begins mid-month for the month the improvements are purchased or completed. [IRC §168(d)(2)]
Trade fixtures are controlled by personal property depreciation schedules, not real estate schedules.
Each separately described parcel of improved real estate has its own depreciation schedule. Depreciation schedules apply to all classes of improved real estate, whether business-related property, rental property or investment property. A residential dwelling put to personal use as the owner’s principal residence cannot be depreciated. A vacation home is depreciable if not occupied by the owner and his family or by his friends (rent-free) for the greater of more than 14 days or 10% of the time rented. [IRC §280A(d)(1)]
Further, the type of real estate owned dictates the depreciation schedule to be used for the depreciation allowance.
Two categories of depreciable real estate have been established for newly acquired property or constructed improvements:
- residential; and
- nonresidential. [IRC §168(e)(2)]
Residential properties include:
- all residential rentals; and
- vacation residences that are rented and occupied during the year by the owner’s family for no more than 14 days or 10% of the days rented, whichever is greater.
Nonresidential properties include:
- trade or business real estate;
- rental real estate other than residential rentals; and
- all depreciable investment (portfolio) category property (property owned and subject to a management-free, triple-net lease). [World Publishing Company v. Commissioner (1962) 299 F2d 614]
Two sets of depreciation schedules exist for both categories of depreciable property:
- a standard income tax (SIT) depreciation schedule; and
- an alternative minimum income tax (AMT) depreciation schedule.
Standard vs. AMT depreciation schedules
The only depreciation tables available for income tax reporting are straight-line. The use of the schedules is mandatory and based on the type of property involved:
- residential rental property: the 27.5-year Standard Depreciation Schedule (SDS) or the 40-year Alternative Depreciation Schedule (ADS) election; and
- nonresidential property: the 39-year SDS or the 40-year ADS election. [IRC §168(c)]
A sales agent filling out a property’s Annual Property Operating Data (APOD) form to project a buyer’s after-tax benefits for the first year of ownership on the proposed purchase of an income-producing property will generally use the 27.5-year and 39-year straight-line depreciation schedules for residential and nonresidential property, not the alternative 40-year straight-line schedule, since they produce a higher annual tax-free recovery of the investment.
Depreciation schedules apply to all classes of improved real estate, whether business-related, rental or investment property.
|An owner may switch to the 40-year straight-line depreciation schedule at any time during his ownership for any parcel of real estate. However, once the 40-year schedule is chosen, the owner cannot revert to the prior depreciation schedule he was using for the parcel. [IRC §168(g)(7)]|
For example, using the 40-year depreciation schedule in place of 27.5- and 39-year schedules reduces or completely avoids a build-up of suspended operating losses for owners who are not in a real estate-related business. An operating loss is typically generated by a highly leveraged acquisition of a rental property when the owner has no reportable operating income from other rental properties to offset this property’s loss. The loss then becomes suspended as the rental loss cannot be commingled with other categories of income.
Also, suspended losses can only be used in future years to offset annual income or resale profits produced by the very property which generated the suspended loss.
Thus, it might be preferable to reduce annual losses in the first years of ownership by using the longer 40-year depreciation schedule so depreciation will remain to offset increased reportable income in later years from both this and other rentals.
Individuals, partnerships, LLCs and corporations depreciate property under the same schedules.
Financially, the depreciation allowance is a deduction from NOI. Thus, depreciation deductions reduce the property’s reportable income, or increase its reportable loss.
In highly debt-leveraged income properties, the combination of interest deductions and depreciation deductions often produces an annual operating loss during the early years of ownership, before inflation and appreciation increase the property’s rental income.
Use of standard 27.5- and 39-year depreciation schedules produces less reportable income (or a greater loss) than use of the AMT 40-year schedule, which produces a greater income (or smaller reportable loss).
Depreciation taxed at 25% on sale
On a sale of depreciable property, a formula of “sales price minus the remaining cost basis” equals profit. For example, a property purchased years ago for $500,000 has a depreciated (remaining) cost basis of $100,000. It is sold for $1,000,000, generating a profit of $900,000. When property on which the owner has taken depreciation deductions is sold at a profit, the total amount of depreciation taken during ownership is taxed at a 25% rate, called unrecaptured gain. Of course, the depreciation recaptured cannot exceed the actual profit on the sale. [IRC §§1(h)(1)(D); 1250(c)]
Here, the $900,000 profit consists of $400,000 in depreciation deductions that reduced the cost basis below the original cost of acquisition, and $500,000 in actual dollar value increase over the original cost of acquisition.
Thus, on a sale at a price exceeding the remaining cost basis, the profit taken up to the price originally paid for the property, plus the cost of any further improvements, is taxed as unrecaptured gain at the 25% rate. [IRC §§1(h)(1)(D); 1250(c)]
The profit taken over the original cost of acquisition and improvements is taxed at the current 15% rate, called long-term capital gains. [IRC §1(h)(1)(C)]