Depreciation is a factor to keep in mind in any commercial real estate transaction. In today’s blog we will offer a basic definition of depreciation as it relates to commercial real estate, as well as a basic formula to calculate the depreciation of a property.
What Is the Depreciation of Real Estate?
Let’s begin by defining the term “depreciation,” a word you may have heard thrown around when talking about taxes.
Simply put, depreciation can be defined as a loss of value.
Most material assets depreciate, which means that they lose value over time. For example, it’s a well-known fact that a car begins losing a portion of its value the moment you drive it off the lot.
The same principle applies to commercial real estate and real estate in general. The depreciation process of a property kicks in as soon that property is placed in service.
Depreciation is a key concept in real estate because tax laws allow property owners to take a deduction to compensate for depreciation.
It’s worth noting that only the buildings or structures lose value over time. Land does not depreciate.
How to Calculate the Depreciation of Real Estate?
The simplest (and most common) way to calculate the depreciation of a property is by using a method known as straight line depreciation, or straight line basis.
With straight line depreciation, you take the value of the property and subtract the land value (land doesn’t depreciate, remember?). Then you divide that total by the amount of years the property may be depreciated according to the IRS.
Since all these concepts can be a little abstract, here’s an example to make it clearer:
- Let’s say you purchase a nonresidential property for $300,000.
- The land was valued at $50,000.
- We’ll subtract the value of the land from the property price, so 300,000 – 50,000 = 250,000
- Now we’ll divide that amount by 39 years, so 250,000 / 39 = 6,410.25
This means that the annual depreciation of the property described above would be $6,410.25.
Finally, keep in mind that this is only a simplified example to illustrate how depreciation works. Many factors come into play when it comes to depreciation, and not all of them are considered in this example.
If you need to calculate the actual depreciation of a property, seek the assistance of an accountant you trust.
Disclaimer: This material is for general information and educational purposes only. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
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