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Depreciation
Depreciation expense is one of the major items of
consideration when evaluating potential equipment or real estate
acquisitions, as it allows the investor to take an "imaginary" deduction
even though the property may be actually appreciating in value.
Depreciation is the periodic expended of an asset over the
property's theoretical economic life. This tax deduction is intended to
recognize the decrease in value caused by wear and tear, outdated interior
improvements, and neighborhood problems.
Depreciation begins when the
asset is placed in service, not necessarily when it is obtained.
Depreciable real property usually is considered to be placed in service
when it has been completed and is ready for occupancy.
Generally, depreciable property is:
1) A capital expenditure in depreciable property.
2) Used in a trade or business or held for production of income
3) Has a definite useful life or more than one year.
Example: Scott purchases a $100,000 rental building in 1998. He instruct his accountant not to make any depreciation on the building, he already has enough deductions to offset his income. In other words, he has no tax use for the depreciation deduction from the building at this time. After holding the property for 39 years, he sells it to Martin for $100,000. He must report to the IRS a $100,000 gain. Depreciation allowed or allowable is required in the capital gains computation.
Gain or Loss Computation
Sales
Price
$100,000
-----------------------------------------------------------------------------------------------------------------------------
Adjusted
Basis
-----------------------------------------------------------------------------------------------------------------------------
Original
cost
$100,000
-----------------------------------------------------------------------------------------------------------------------------
+
Improvements
-----------------------------------------------------------------------------------------------------------------------------
- Accumulated
Depreciation
-$100,000
-----------------------------------------------------------------------------------------------------------------------------
= Total Adjusted
Basis
$0
-----------------------------------------------------------------------------------------------------------------------------Net
gain (or loss) on sale (Net Selling Price - Total
Adjusted
Basis)
$100,000
Deductible or Depreciable?
Let's look at an example of Navia Campbell vs. IRS. Navia Campbell was entitled to deduct the cost of removing and replacing the roof covered material on her residential rental house as a trade business expense. A quote from the case "The tenant complained to Campbell and, as Campbell put it in lay person's terms: "Se we have to get it repaired:. She could not have continued to rent the house if the roof had continued to leak". The contractors removed existing top layers of the roof and recovered it with fiberglass sheets and hot asphalt. They made no structural changes to the roof. The $8,000 of removing and replacing the roof covering material is the amount in issue. Campbell claimed it was a deductible expense; the IRS argued it was a capital expense.
The court observed that Campbell's only purpose for the
expense was to prevent leakage and keep her rental house in an operating
condition over its probable useful life and not to prolong the life of the
property, increase its value, or it adaptable to another use. There was no
replacement or substitution of the roof in this case.
Land cannot be depreciated because taxpayers cannot calculate, what would be the life of the land. When improved property is purchased, the taxpayer must allocate the purchase price between the land, building and other improvements. The allocation must be done in a fair and equitable manner, based on the relative fair market values at the time of purchase. On other words, when improved property is purchased, the lump sum price is divided between the depreciable property and the land in the same proportion of each to the total cost.
Example: Randy acquired a piece of property for $100,000
lump sum purchase price. An appraisal shows the land to be worth $50,000
and the building to be worth $150,000. The $100,000 is allocated as
follows:
Land: ($50,000 / ($50,000 + $150,000)) x $100,000 =
$25,000
Building: ($150,000 / ($50,000 + $150,000)) x $100,000 =
$75,000
$25,000 + $75,000 = $100,000
Depreciation Methods:
The calculation of depreciation has been determined
under one of the following three methods: (1) economic life, (2) ACRS, (3)
MACRS. As the acquisition date of the property determines which methods
are available, below are the alternative depreciation methods and related
depreciable lives available to investors.
Real Property Placed in
Service Date Between: The Depreciable Life
Is:
| Real Property Placed in Service Date Between: | The Depreciable Life Is: | ||
| February 12,1913 - December 31, 1980 | Economic Life | ||
| January 1,1981 - March 14,1984 | 15 years - ACRS | ||
| March 15,1984 - May 8, 1985 | 18 years - ACRS | ||
| May 9, 1985 - December 31,1986 | 19 years - ACRS | ||
| January 1,1987 - May 12,1993 | 27.5 / 31.5 years - MACRS | ||
| May 13,1993 - present | 27.5 / 39 years - MACRS |
Economic Life. For asset placed in service before 1981,
and for assets not eligible for ACRS or MACRS, property is depreciated
over the asset's economically useful life (how long that asset is
economically profitable).
Straight Line Depreciation.
This term means that the property is expensed evenly over the life of the loan. For example: $100,000 building with an estimated life of $50 years would be depreciated at the rate of $2,000 each year.
Useful economic life is determined by all the facts and
circumstances in each casa. For eligible properties, depreciation expense
is generally calculated by the intermixing of three major elements:
1)
The method of depreciation to be used (straight line, declining balance,
sum of the year's digits)
2) The value of the property that is
depreciable (land and salvage value is required to be subtracted)
3)
The economic life of the property
Beginning January 1, 1987,
all tangible depreciable property purchased and issued is expended using a
straight line or accelerated depreciation method over normally longer
predetrmined recovery periods.
The IRS prescribes the depreciation
percentages to be applied to both personal and real property. A specially
computed percentage is applied to these classes. All property is assigned
to eight classes. There are six classes for depreciable personal property
and two classes for real property.
The first six classes-
3,5,7,10,15 and 20 year are personal property classes.
Check IRS guidelines first to determine property classifications within these six classes, the taxpayer must first refer to the properties "Class Life (in years)" under the IRS's Asses Depreciation Range (ADR) system. This class life is the property's midpoint life and indicated the average useful life of an asset. The average lives are based on prior IRS research of broad industry and classes of assets. The purpose of the class life ADR system is to keep conflicts over individual useful lives at a minimum.
Items depreciable worth noting. Real Estate Investors use
often some of the below listed personal property items:
-Stoves,
refrigerators, apartment furniture and similar items are depreciable in
the 5 years class (see57.0 asses guideline ADR class)
-Computers, adding machines, typewriters, and photocopy machines are depreciable in the 5 years class. (see 00.12 and 00.13 ADR class)
-Office furniture, fixtures and equipment are depreciable in
the 7 year class (see 00.11 ADR class)
-Agriculture machinery and
equipment are depreciable in the 7 year class using the 150%
declining-balance rate (see 01.1 ARD class)
-Construction Equipment is depreciable in the 5 year class )see 15.0 ADR class)
- Single use agricultural buildings (such as grain bins and silos) are in the 10 year class (see 01.4 ADR class)
-Land Improvements are the 15 year 150% declining class and are described in ADR class 00.3 as follows: "includes improvements directly to or added to land, whether such improvements are section 1245 property or section 1250 property, provided such improvements are depreciable. Examples of such assets might include sidewalks, roads(paving), canals, waterways, drainage facilities, sewers (not including municipal sewer in Class 51), wharves and docks, bridges, fences, landscaping"
-Farm buildings are in the 20 year class (see ADR class 1.3)
-Municipal sewer pipes are in the 20 years class (ADR class
51)
The last two classes are for (1) residential rental real
property and (2) nonresidential rental (commercial) property.
27.5 year
(straight line) residential rental real property class.
The IRS defines the property to be included in this class as residential rental property such as duplex, apartment, condominium units, and cooperative units used as personal residences and are alike. It specifically does NOT include hotels and motels.
The technical definition of residential rental property is a building in which 80% or more of the gross rental income comes from dwelling units. The terms dwelling units is defined as a houses or apartment used to provide living accommodations, but does not include a unit in a hotel, motor inn, or other establishment in which more than one-half of the units are used in a transient basis.
Example: Marvin own five floor apartment complex with a grocery store on the first floor. The 2003, the residential tenants pay him $150,000 a year gross rent, and the commercial tenant pays him $50,000. Even though the residential portion of the building comprises 80% of the total floor space, it is irrelevant.
The total building must be depreciated as a 39 year commercial building as the residential tenant's gross rent comprises only 75% of the total rental income.
31.5 Year life. For acquisitions between January 1,1897 - May 13,1993 this commercial real estate must be depreciated over 31.5 years using the straight-line method.
39 year life. Effective for purchases after May 12,1993;
commercial real estate must be depreciated over 39 years using the
straight-line method.