How Depreciation on Commercial Real Estate Investment Can Impact Your Taxes

To the untrained investor, depreciation is seen as something that should be avoided at all costs. However, seasoned financial experts understand that depreciation is a normal part of the investment cycle and can even be leveraged to lessen your tax burden. 

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Let’s examine depreciation, how it applies specifically to real estate, and how smart investors use it to reduce their taxes. 

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What is Depreciation on Commercial Real Estate (CRE?

In CRE, depreciation refers to the tax deduction process where the cost of a property is written off gradually over its useful life. This applies to the physical structures on the property, such as buildings, but not to the land itself, as land is not considered a depreciable asset. For tax purposes in the United States, the IRS assigns a useful life of 39 years to commercial properties, meaning the building's value can be deducted in equal portions (using the straight-line depreciation method) over that period. 

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Depreciation allows property owners to recover the cost of the structure's wear and tear, aging, and obsolescence, effectively reducing taxable income. CRE investors can use depreciation to improve cash flow and manage their tax obligations better.

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Commercial and Residential Real Estate and Their Depreciation

Commercial and residential real estate differ in their primary use, tenant type, and how the IRS handles depreciation. CRE includes properties used for business purposes, such as office buildings, retail spaces, industrial facilities, and warehouses. These properties are typically leased to businesses or organizations to support commercial activities. In contrast, residential real estate comprises properties designed for living purposes, such as single-family homes, apartments, condominiums, and multifamily residences, which are rented to individuals or families for accommodation.

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The IRS applies distinct depreciation schedules to these property types under the modified accelerated cost recovery system (MACRS). CRE is categorized as nonresidential property and is depreciated over 39 years using the straight-line method and the midmonth convention. This longer recovery period accounts for commercial structures' typically more durable nature. Conversely, residential real estate is depreciated over a shorter period of 27.5 years under the same straight-line method and mid-month convention. The shorter depreciation period for residential properties reflects their faster wear and tear and generally shorter lifespan than commercial properties.

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These differences influence the annual depreciation deductions available to investors. Residential properties offer larger yearly deductions due to the shorter recovery period while commercial properties typically involve longer-term tax planning.

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Why CRE Can Offer More Deductions

While residential real estate may seem appealing due to its shorter depreciation period of 27.5 years, CRE offers opportunities for larger and more rewarding tax deductions when strategic methods such as cost segregation studies and bonus depreciation are applied. By leveraging these advanced tax strategies, investors in commercial properties can accelerate depreciation, increase upfront deductions, and maximize their tax savings in ways that go beyond the benefits typically associated with residential investments. Here’s how CRE investors can achieve greater financial rewards.

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1. Cost Segregation Studies: Accelerating Depreciation

A cost segregation study involves analyzing and separating specific components of a commercial property, such as lighting systems, heating, ventilation, and air conditioning (HVAC) units; plumbing; and fixtures. These components often qualify for shorter depreciation schedules — typically five, seven, or 15 years instead of the standard 39 years used for the overall building.

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A qualified professional, such as an accountant or engineer, conducts the study to identify which parts of the property can be reclassified into shorter recovery periods. By shifting components to shorter depreciation schedules, you can accelerate deductions, increasing upfront tax benefits. For example, instead of spreading the cost of an HVAC system over 39 years, it can be depreciated over 5 years, significantly boosting early deductions.

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2. Bonus Depreciation: Larger Deductions in Year One

Under the Tax Cuts and Jobs Act (TCJA), investors can claim bonus depreciation on qualifying property components with a useful life of 20 years or less. Many elements identified in a cost segregation study, such as equipment and fixtures, qualify for this treatment.

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Bonus depreciation allows you to deduct the total cost of qualifying assets in the year they are placed in service rather than spreading the deduction over several years.

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For example: If a commercial property has $200,000 worth of qualifying components, you could deduct the total of $200,000 in the first year instead of over five, seven, or 15 years. This significantly reduces taxable income upfront and improves cash flow.

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3. Larger Asset Size and Value: Greater Depreciation Potential

Commercial properties typically are larger and more expensive than residential properties, meaning their total depreciation potential is higher, even though it is spread over a longer period (39 years).

• Example:
  • A $5 million commercial property offers more total depreciation than a $500,000 residential property, even though the annual deductions may be smaller due to the longer recovery period.

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With cost segregation and bonus depreciation, the initial deductions for commercial properties can be dramatically increased.

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4. Special Rules for Leasehold Improvements: Shorter Recovery Periods

Specific improvements to commercial properties, such as interior remodeling, may qualify for shorter depreciation periods under IRS rules. These improvements can often be depreciated over 15 years instead of 39 years.

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If the improvements meet specific criteria, such as being part of a tenant lease agreement, they can be reclassified for faster depreciation, further enhancing tax benefits.

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How Is Depreciation Calculated?

When calculating depreciation on real estate, the IRS recommends using two methods: the general depreciation system (GDS) and the alternative depreciation system (ADS). Here’s how depreciation works and how you can calculate it for your property.‍

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1. Determine If Your Property Is Eligible for Depreciation 

The critical criteria are:

• You own the property (even if it’s financed).
• The property is used for income-generating activities, like renting it out.
• The property naturally depreciates over time (excluding land).
• It has a useful life of more than one year.

Next, you calculate the basis of your property, which is the acquisition cost. This includes the purchase price, installation fees, freight charges, and other related expenses. Be sure to subtract the land cost, as land is not depreciable. Adjust for additional costs or income until the property is ready to be rented out — this adjusted figure becomes your basis for depreciation.

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2. Select the Appropriate Depreciation Method

1. GDS: This method is most commonly used for residential and commercial properties. It uses the straight-line method, which spreads the deduction evenly over the asset’s useful life (27.5 years for residential rental property and 39 years for commercial property).

The formula for straight-line depreciation is:(Asset Cost – Salvage Value) ÷ Useful Life

• Asset cost: The purchase price of the asset.
• Salvage value: The estimated value of the asset at the end of its useful life.
• Useful life: The number of years the asset is expected to be in use.

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How it works:
To determine the annual depreciation expense, you subtract the salvage value from the asset's cost and divide the result by the asset's useful life. This provides a consistent annual deduction.

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‍Example:
Imagine you run a party rental business and purchase a bouncy castle for $10,000. Its salvage value is $500, and it has a useful life of 10 years. Using the formula:

(10,000 – 500) ÷ 10 = $950

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You would write off $950 from the bouncy castle’s value each year for 10 years.

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In CRE, straight-line depreciation often applies to structures (not the land) with a useful life of 39 years. For example, if a commercial building costs $390,000 and has no salvage value, you would deduct $10,000 annually over 39 years. This method provides consistent deductions, simplifying tax planning and financial reporting.

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ADS: This method applies if the IRS requires you to use it for specific properties or if you choose to use it. ADS spread the deductions over a more extended period, resulting in more minor annual deductions, but could be beneficial in certain situations. 

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Here’s how ADS depreciation is calculated:

• Identify the Asset and its ADS Recovery Period:some text
  • The IRS provides a list of recovery periods for assets under ADS. For example, CRE under ADS has a 40-year recovery period instead of the standard 39 years under the MACRS.
• Use the Straight-Line Method:some text
  • Similar to MACRS for nonresidential property, ADS uses the straight-line depreciation method. This means the same amount is deducted each year over the recovery period.
• Apply the Formula:some text
  • The formula for calculating annual ADS depreciation is:
    (Asset Cost – Salvage Value) ÷ ADS Recovery Period
• Example Calculation:some text
  • Let’s say you purchase a commercial property with no salvage value for $400,000. Under ADS, the recovery period is 40 years.
    $400,000 ÷ 40 = $10,000
    You would deduct $10,000 annually for 40 years.
• When to Use ADS:
  • The IRS may require ADS for certain properties, such as those used primarily outside the U.S. or for tax-exempt purposes.
  • Taxpayers may also choose ADS if they prefer smaller annual deductions to preserve depreciation deductions for later years.
• ADS provides a more conservative approach to depreciation, allowing for consistent deductions over a longer period. It’s often used for strategic tax planning or to comply with IRS requirements for specific property types.

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If you decide to sell the property for more than its original cost, minus the depreciation you've claimed, you may owe a depreciation recapture tax. This tax is on the amount of depreciation you've taken and is considered ordinary income, taxed at a rate of 25%. Discuss this with your accountant to ensure you're prepared for any tax obligations when selling.

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The Impact and Benefits of Depreciation for Real Estate Investors

Depreciation offers real estate investors significant tax benefits by reducing their taxable income and, consequently, their tax liability. By deducting a portion of the property's value each year, depreciation allows investors to report less income to the IRS, thereby lowering the amount of taxes owed.

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This tax-saving mechanism is particularly advantageous for property owners with rental income. Depreciation is treated as a deductible expense, offsetting income generated by the property. Additionally, depreciation can offset other taxable income, further reducing overall tax obligations. However, investors should note that depreciation must be recaptured and taxed when the property is sold, although this often comes at lower capital gains tax rates. 

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The table below shows the impact of depreciation on a property's income statement in two scenarios: with and without depreciation.

Without depreciation, the property generates a pretax income of $30,000. However, when a $5,000 depreciation expense is applied, the pretax income is reduced to $25,000. This reduction in pretax income lowers the taxable amount, leading to a smaller tax liability. For example, at a 20% tax rate, the taxes owed without depreciation would be $6,000 ($30,000 × 20%). With depreciation, the taxes owed drop to $5,000 ($25,000 × 20%). This creates a tax savings of $1,000, showcasing the financial benefit of applying depreciation to real estate investments.

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Securing Your Real Estate Investment During Depreciation

When property values decline, it’s essential to protect your investment. Here are some strategies to consider:

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• Diversify your portfolio: Invest in different types of properties or markets to spread risk.
• Focus on cash flow: Prioritize properties that generate consistent rental income to offset any losses from depreciation.
• Enhance property value: Make improvements or upgrades to increase the property's appeal and value, helping it withstand market fluctuations.
• Stay informed: Monitor market trends and local economic conditions to make informed decisions about buying, selling, or holding properties.
• Consider long-term holding: If you believe in the long-term value of your investment, holding onto the property can help you ride out temporary downturns.
• Utilize depreciation benefits: Take advantage of tax deductions from depreciation to improve your cash flow during down markets.

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Trust the experts: Invest with reliable property experts. These experts help investors effectively navigate higher purchase costs, competitive markets, and complex management.

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Maximize Tax Benefits and Diversify Your Portfolio

Navigating the complexities of depreciation and its tax implications requires a strategic approach. At Alliance CGC, we help investors reduce their tax liabilities through depreciation, secure a steady income, and protect their investments by offering access to diversified real estate opportunities. Here's how we can assist:

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• Diversify to protect your portfolio: Spread risk and enhance returns by investing in high-performing asset classes, such as medical office, multifamily, retail, industrial, and veterinary properties. Diversification helps safeguard your portfolio against market fluctuations.
• Ensure consistent cash flow: Alliance specializes in properties with consistent and reliable rental income, ensuring steady cash flow to offset any potential financial impacts of depreciation.
• Provide insights from industry leaders: Leverage our 30-plus years of experience and deep industry knowledge to make data-driven decisions in buying, selling, or holding properties.
• ‍Access to resilient portfolio: Trust Alliance to guide you in building a resilient portfolio that withstands temporary downturns while maximizing long-term value.

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Partner with Alliance CGC to access expert strategies, diversified property opportunities, and the tools you need to maximize tax benefits while securing your income. Invest with Alliance today!