Property Depreciation

Property depreciation refers to the reduction in the value of a property over time due to wear and tear, allowing owners to subtract costs from their taxable income. It aims to spread deductions throughout the useful life of a property, specifically for residential rentals, as outlined by the Internal Revenue Service (IRS).

It helps minimize tax obligations, making real estate investment more financially viable for property owners. Depreciation works by spreading the cost of the property over its useful lifecycle. It applies to different classes of assets, such as rental properties, equipment, and machinery, but not land, as its value appreciates.

Property depreciation is an accounting technique used to allocate the cost of real estate properties over their useful life. This process accounts for an asset’s value decline due to factors like weathering, obsolescence, or other miscellaneous reasons. 

Property depreciation influences decision-making, as it affects financial reporting, property taxes, and investment strategies. It is essential for evaluating a property's financial health and tax planning. Depreciation ensures that asset values are accurately reflected in financial statements, preventing the overstatement of profits. Investors and property owners use depreciation to offset property acquisition costs and improvements, effectively reducing tax liabilities.

Depreciation for rental properties begins when the property is put into service—such as being used for rental activities—allowing owners to deduct a small portion of the property's cost annually. The IRS uses the Modified Accelerated Cost Recovery System (MACRS) for U.S. residential rental assets, which have a standard recovery period of 27.5 years, depreciating at a rate of 3.636%  annually. This means the rental property owner can claim depreciation from the federal government until the end of the stipulated period. As long as the owner holds the property, they can deduct the depreciation from their taxable income each year. This reduces the owner's tax burden and may even lower their income tax bracket. 

Commercial property depreciation can occur due to several causes:

• Market trends
• Declining infrastructure around the property or poor maintenance negatively impacts its value.
• Unfavorable changes in government policies, such as zoning or tax law changes, which can lower property prices.
• An oversupply of real estate in a particular location reduces demand and drives down property values.
• Unfavorable weather conditions or locations prone to natural disasters can also lead to depreciation.

There are different methods for calculating property depreciation, depending on the type of asset and the purpose. One of the simple and common method is the following:

Straight-Line Depreciation Method

This method assumes that the property depreciates by a fixed amount each year over its useful life.

Formula:

Annual Depreciation = (Cost of the property – Salvage value)/Useful life of the property

• Cost of the Property: The initial purchase price.
• Salvage Value: The estimated value of the property at the end of its useful life
• Useful Life: The expected number of years the property will be used.

Some of the examples are the following:

Example #1 

Austrian real estate developer Immoeast reported a first-quarter operating loss of  261.4 million euros, primarily due to property depreciation and currency effects in emerging European markets. This marks a sharp reversal from the 93.1 million euro profit in the same period last year. The company's property portfolio, valued at over 10 billion euros, saw a 294 million euro drop in value, with 188 million euros attributed to currency fluctuations. Despite a 33% rise in revenue to 85 million euros, the depreciation in asset values has significantly impacted its performance, with shares falling 59% this year.

Example #2

Let us assume that David has a rental property in Old York City, bought for $400,000, with a residual value of $50,000 and a useful life of 27.5 years (as per IRS rules for residential rental property). He puts the property into rental service on January 1, 2024. David uses the straight-line method to determine the annual depreciation, as shown below:

• Original Cost = $400,000
• Residual Value = $50,000
• Useful Life = 27.5 years

Substituting the above values in the formula below:

Annual Depreciation = (Original Cost - Residual Value) / Useful Life

• = $400000-$50000/27.5
• = $12, 727.27 per year

Annual Depreciation: $12,727.27 per year starting from 2024

Since the property is placed into service on January 1, David can claim the full year’s depreciation of $12,727.27 for 2024 and every subsequent year over the 27.5-year period.

By utilizing depreciation, David reduces his taxable rental income and benefits from significant tax savings, enhancing the return on his investment. He will monitor accumulated depreciation each year to ensure his financial statements reflect the declining value of the property correctly.

Depreciation in property leads to tax deductions in the following manner:

• Property owners can recover the expenses related to income-generating properties through yearly tax deductions.
• The IRS allows depreciation on residential rental properties over a recovery period of 27.5 years at a rate of 3.6% annually.
• Depreciation starts as soon as the property is placed in service and continues until the owner has fully recovered the investment cost or the property is no longer in use.
• Only the property qualifies for depreciation; the land it is built does not.
• However, when selling a rental property, owners may face depreciation recapture taxes of up to 25%, which can affect their total capital gains tax liability.