I remember a client of mine explained to me years ago that there are four reasons someone invests in Commercial Real Estate:
- Appreciation – the idea that the property is worth more over time – it appreciates
- Cashflow – the very real dollars that the property pays on a regular basis as the tenant(s) pay rent
- Equity – the rents also provide the dollars needed to pay down the loan on the property reducing the principal owed and increasing equity. In essence, the tenants are paying the loan payment for you.
- Depreciation – the subject of this post and the most misunderstood of the four.
The text book definition of depreciation is this: the monetary value of an asset decreases over time due to use, wear and tear, or obsolescence. This decrease is measured as depreciation. In simple terms, depreciation means you do not pay as much income tax as you would have otherwise. Let me give you an example.
I have a client who is closing on a retail investment property next week. He is going to pay approximately $2,400,000 for the property. Because of the depreciation, he will reduce the amount of taxes he pays by nearly $20,000…a year!
Here is how it works. The federal government wants you to invest in commercial real estate. And because buildings wear out over time, they let you depreciate the value of the property over time. For commercial properties like retail, office, industrial, self-storage, etc., you are allowed to depreciate the value over 39 years. For residential properties like single family rentals or apartments, you can depreciate the value over 27.5 years. Don’t ask me where 39 and 27.5 years come from – I have no clue.
- You can’t depreciate land. Land is considered to be indestructible and perpetual. Buildings wear out, but the dirt below it doesn’t. My client doesn’t get to depreciate $2,400,000 for the property he is buying. He will allocate around $500,000 in value to the land, and the remaining $1,900,000 is allocated to the building. He will then depreciate $1,900,000 over 39 years or $48,717.95 a year.
- Depreciation is a phantom expense. The way my client will use the depreciation of $48,717.95 a year is to reduce his taxable income. It is an expense line item on his tax return that he doesn’t actually have to pay. For example, if my client makes $400,000 in 2022, his taxable income would be reduce by $48,717.95, and he would pay taxes on $351,282.05. If his tax rate with federal and state taxes is around 40%, his tax savings would be $48,717.95 x 40% – or $19,487.18. Not bad!
- Depreciation only reduces passive income. Passive income is defined as income generated by activities that lack your material participation. Rental income qualifies as passive income. If you own a business but aren’t involved in the day to day operations, that would be passive income. It does not reduce W-2 income. Unless…you are a real estate professional. If you are a real estate professional, ALL of your income is eligible to be reduced by depreciation. To qualify as a real estate professional per the IRS, half of your work must be in the real estate profession (broker, developer, agent, etc.), and you must spend 750 hours in the tax year doing that work. (If you are generally an awesome human and are interested in becoming a real estate professional, let me know. I’m always looking for great talent!)
- You will get taxed when you sell the property. This one surprises people. The federal government give us this awesome tax deduction, but Uncle Sam is going to get his eventually. This tax is called cost recovery, and it is triggered when you sell the property. For every dollar your depreciated, you have to give your silver-haired uncle a quarter. So let’s say my client keeps his property for ten years. He would depreciate his retail center by $487,179.50 over those 10 years. When he sells, he will have to pay the government cost recovery tax of $121,794.88. Is that a good deal? It’s not as good as pay no tax, but I’ll take this deal. He will save around $195,000 while he owns the property because of depreciation, but will pay $121,794.88 when he sells. I’ll take that deal every time.
There is a way to indefinitely defer the cost recovery tax (as well as capital gains tax) when you sell commercial real estate. It is the method I use, and most of my clients use, to completely avoid paying this tax – as well as capital gains tax. If you would like to learn more about this method, I’ve written a short ebook that you can download by clicking the button below. It explains how to execute a 1031 Tax-Deferred Exchange which is one of the most powerful wealth building tools available for commercial real estate.