Cost recovery, also commonly known as depreciation, is tax concept implemented by the Internal Revenue Service that is roughly defined by the tax code as a loss in value to a property over time as the property is being used.
Depreciation forms the basis for a major part of a real estate investor’s tax shelter during rental investment property ownership. And, in fact, depreciation deductions are one of the essential benefits of real estate investing.
In this article we’ll discuss this tax shelter method to give you the general idea of how it works. Including its application, as well as the various components and formulation to calculate depreciation allowance deductions.
Before we get started, though, allow me to point out I will be using the terms “cost recovery” and “depreciation” interchangeably in this discussion. However, each method is technically different. In fact the IRS introduced the more recent term “cost recovery” because of frequent issues that resulted from the previous term “depreciation.”
In actuality, however, it’s mostly a technical matter with differences that matter little to most taxpayers. So for our purposes, we’ll leave a more complete explanation to the qualified tax consultants and simply refer to both terms interchangeably.
The IRS regulates which types of real estate is eligible for depreciation, and therein it recognizes by the tax code to qualify for depreciation deductions, according to the following limitations.
- The property must be used in a trade or business or held for the production of income (an individual’s personal residence does not qualify)
- The property must have a determinable useful life longer than a year
- The property must be something that wears out, becomes obsolete, or losses its value from natural causes (the land component of the investment property cannot be depreciated)
According to the tax code, depreciation can be applied to a real estate investment when the property is placed in service for a specified use; even if it is not immediately used for the intended purpose.
An entire apartment complex with several vacancies, for instance, would qualify for cost recovery because the units (though not fully occupied) are ready and available for use. Likewise, a new property may be considered in service when a certificate of occupancy has been granted.
There are four components required to calculate the cost recovery deductions.
This is typically the original cost of the property plus capitalized costs of acquisition such as broker’s fees, appraisal fees, survey fees, title insurance, etc. As the investment is depreciated, the original basis minus accumulated depreciation results in an adjusted basis.
For example, a property purchased for $297,000 with acquisition costs of 3,000 would have an original basis of $300,000. Subsequently, accumulated depreciation would be deducted from that amount to calculate an adjusted basis.
2. Depreciable Basis (Cost Recovery Basis)
This is the overall basis minus the value of nondepreciable land. Since this must be justifiable, a good way to do this is by examining the tax assessments to see how they separate the value of the buildings from the value of the land. The dollar amounts they use may be less than the purchase price, but the proportion should prove meaningful.
For example, if the tax assessments are showing that the buildings for a rental property you are purchasing are 70% of its value, than it would likely be defensible for you to allocate $210,000 as a depreciable basis when paying $300,000 for the property.
3. Class and Cost Recovery Period
This determines the investment property’s class and appropriate recovery period. A property is classified as “residential” if 80% or more of the gross income is derived from dwelling units. This is considered by the IRS to have a useful life of 27.5 years. Rental property not classified as residential is classified as “nonresidential”. This is considered by the tax code to have a useful life of 39.0 years.
4. Date Placed in Service
This is the date the property is placed in service and determines the amount of first-year depreciation and the amounts for all future years in the holding period.
As stated earlier, an existing rental property is considered placed into service when the real estate investor takes ownership. A newly constructed apartment complex is considered placed into service when a certificate of occupancy is granted by the local code enforcement authority.
Depreciable Basis / Useful Life = Depreciation Allowance (annual)
Okay, let’s say you purchase an office complex and than draw the $210,000 depreciable basis we illustrated above.
$210,000 / 39 = $5,385 (annual Depreciation Allowance)
So You Know
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