Depreciation
Also called Cost recovery, Straight-line depreciation.
Depreciation is the annual deduction that lets an owner recover the cost of a building over a fixed period set by statute. It reduces taxable income without reducing cash flow, which is why after-tax returns on real estate exceed pre-tax returns more often than in most asset classes.
How it works
Only the improvements are depreciable. Land is not, so the purchase price has to be allocated between the two, typically using the assessor's ratio, an appraisal or a cost segregation study. That allocation is one of the more consequential judgements in real estate tax, because it directly sets the size of every subsequent deduction.
The recovery periods are set in statute: residential rental property over 27.5 years and non-residential real property over 39 years, both straight line. A property producing positive cash flow can therefore show a taxable loss, and that gap between book and cash is the mechanism behind most real estate tax planning.
Depreciation is a deferral, not an exemption. Every dollar deducted lowers the adjusted basis, and a lower basis means a larger gain on sale. Some of that gain is then taxed as recapture at rates above the long-term capital gains rate. An after-tax model that shows the deductions without showing the recapture at exit is not showing the deal.
Formula
Annual depreciation = (purchase price - land value) / recovery period- Recovery period is 27.5 years for residential rental property and 39 years for non-residential real property, both straight line
- Land is never depreciable, so the price allocation between land and improvements sets the size of the deduction
- Capital improvements are depreciated separately over their own recovery periods from the date they are placed in service
- The first and last years are prorated by the applicable convention, mid-month for real property, so neither is a full year's deduction
Worked example
Residential property purchased for $55,900,000 with 20 percent of the price allocated to land. Five-year hold, shown as five full years to keep the arithmetic visible; the first and last years would be prorated in practice.
| Depreciable basis | $44,720,000 |
|---|---|
| Annual depreciation over 27.5 years | $1,626,182 |
| Year-one cash flow after debt service | $712,728 |
| Taxable income after depreciation and interest | negative |
| Accumulated depreciation after five years | $8,130,909 |
| Reduction in adjusted basis at sale | $8,130,909 |
Positive cash flow and a taxable loss at the same time, and $8.1 million of basis consumed to get there. That basis reduction is what triggers recapture on sale, and it is the other half of the transaction.
The common mistake
Underwriting the deduction and ignoring the exit
A model that runs depreciation through the annual tax line and then computes a pre-tax sale is not an after-tax model. It shows the benefit and hides the cost. Every dollar of depreciation reduces adjusted basis, increases the gain on sale, and creates recapture taxed above the long-term capital gains rate. The deduction and the recapture belong in the same model, and the honest measure is the after-tax IRR across the full hold including the sale. Tax treatment depends on individual circumstances and this is a description of mechanics, not tax advice.
Related terms
- Depreciation recaptureDepreciation recapture is the portion of the gain on sale attributable to depreciation previously deducted, taxed at a rate above the long-term capital gains rate. For real property the recaptured amount is unrecaptured section 1250 gain, subject to a statutory rate cap of 25 percent.
- Cost segregation and bonus depreciationA cost segregation study reclassifies parts of a building into shorter-lived asset categories, typically five, seven and fifteen year property. Bonus depreciation then allows a percentage of that reclassified basis to be deducted immediately rather than over the shorter schedule.
- Section 1031 exchangeA section 1031 exchange lets an owner defer capital gains tax and depreciation recapture on the sale of investment real property by reinvesting the proceeds into like-kind replacement property within statutory deadlines. It is a deferral, not a forgiveness: the deferred gain carries into the basis of the new property.
- Net operating incomeNet operating income is a property's effective gross income less all operating expenses, before debt service, income taxes, depreciation and capital expenditure. It is the figure a cap rate is applied to, the numerator of debt yield and DSCR, and the number a purchase price is ultimately negotiated against.
Keep reading
Every figure, traced to its source
Altyst computes these in exact decimal arithmetic, not with a language model, and clicking any number shows the formula behind it.