Depreciable Realty: Understanding Depreciable Real Estate

An in-depth explanation of depreciable realty, including criteria for depreciation, legal frameworks, and practical examples.

Depreciable realty refers to real estate properties that are subject to income tax deductions for depreciation. These properties are typically used in a trade or business or held for the production of income. Depreciation is an accounting method that allocates the cost of a tangible asset over its useful life. It is important to note that while buildings and certain improvements to land are depreciable, the land itself, in general, is not depreciable.

Criteria for Depreciation

Trade or Business Use

To qualify for depreciation, the property must be utilized for business purposes. Residential rental properties, commercial buildings, and industrial structures all fall under this category.

Example: A company purchasing an office building can depreciate the building over time but cannot depreciate the land upon which it stands.

Investment Properties

Properties held as investments that generate income, such as rental properties, are also subject to depreciation.

Example: An apartment complex owned by an investor and leased to tenants can be depreciated.

IRS Section 167

Depreciation for depreciable realty is governed under Section 167 of the Internal Revenue Code (IRC), which allows for depreciation deductions of property used in a business or held for income production.

$$ \text{Depreciation Expense} = \frac{\text{Cost of Asset} - \text{Salvage Value}}{\text{Useful Life}} $$

Non-Depreciable Elements

Land

Land itself is typically not subject to depreciation because it does not wear out, become obsolete, or get used up.

Depletable Resources

Land containing natural resources such as minerals, oil, or gas may be subject to depletion rather than depreciation.

Special Considerations

Improvements

Qualifying improvements to depreciable realty that increase its value or prolong its usefulness can also be depreciated.

Residential vs. Non-Residential

Depreciation schedules differ based on whether the property is residential or non-residential. For example:

• Residential rental property: Depreciated over 27.5 years using the Modified Accelerated Cost Recovery System (MACRS).
• Non-residential real estate: Depreciated over 39 years also using MACRS.

Practical Examples

Example 1: Office Building

A company buys an office building for $1,000,000. Using the straight-line method, and assuming a useful life of 39 years, the annual depreciation expense would be:

$$ \text{Depreciation Expense} = \frac{1,000,000}{39} = \$25,641 $$

Example 2: Residential Rental Property

An investor purchases a residential property for $550,000 (building value only). The annual depreciation using the 27.5 years MACRS schedule would be:

$$ \text{Depreciation Expense} = \frac{550,000}{27.5} = \$20,000 $$

FAQs

What is the difference between depreciation and depletion?

Depreciation is applied to physical structures like buildings. Depletion applies to natural resources on the land, such as minerals, oil, and gas, which are consumed over time.

Can all improvements to real property be depreciated?

Not necessarily. Only improvements that materially add to the property’s value or prolong its useful life can be depreciated. Regular maintenance cannot be depreciated.

How often can you depreciate realty?

Depreciation is typically assessed annually over the useful life of the property according to the IRS guidelines.

References

• Internal Revenue Code (IRC) Section 167
• IRS Publication 946 - How to Depreciate Property

Summary

Depreciable realty encompasses real estate used in business or for income production that can be depreciated under IRC Section 167. Understanding which components and improvements are depreciable and the correct application of depreciation schedules (27.5 years for residential, 39 years for non-residential) is essential for accurate accounting and tax reporting.

By thoroughly comprehending depreciable realty, investors and businesses can effectively manage their financial statements and optimize tax benefits.