# Introduction

Depreciation is a term that is commonly used in commercial real estate but can be confusing for many property owners. It is a tax-deductible expense that can help reduce the amount of taxes owed on a property. Depreciation is an integral part of a commercial real estate investment strategy, and understanding how it works can make a significant difference in the overall profitability of a property.

## What is Depreciation?

Depreciation is the process of allocating the cost of a property over its useful life. It is a non-cash expense, which means that it does not represent an actual cash outflow. Instead, it is an accounting method used to spread out the cost of an asset over its useful life. In the case of commercial real estate, depreciation is calculated based on the value of the building and improvements, not the land.

## How is Depreciation Calculated?

Depreciation is calculated using a formula that takes into account the cost of the property, the useful life of the property, and the salvage value. The cost of the property includes the purchase price, closing costs, and any improvements made to the property. The useful life of the property is determined by the IRS and varies depending on the type of property. The salvage value is the estimated value of the property at the end of its useful life.

The formula for calculating depreciation is as follows:

Depreciation = (Cost of Property – Salvage Value) / Useful Life

For example, let’s say you purchased a commercial property for \$1,000,000 with a useful life of 39 years and a salvage value of \$100,000. The calculation for depreciation would be as follows:

Depreciation = (\$1,000,000 – \$100,000) / 39 = \$23,077.

## The Benefits of Depreciation

Depreciation can have significant tax benefits for commercial real estate investors. By reducing the taxable income of the property, depreciation can lower the amount of taxes owed. This can help increase the cash flow of the property and improve the overall profitability of the investment. Additionally, depreciation can help defer taxes until the property is sold, allowing investors to keep more of their money invested in the property.

Another advantage of depreciation is that it can help increase the value of the property. As the property depreciates, its value on the balance sheet decreases. This can make the property more attractive to potential buyers, as they can purchase the property at a lower value.

## Depreciation Recapture

It is important to note that when a property is sold, the IRS requires the recapture of any depreciation that was previously taken. This means that the amount of depreciation that was deducted from taxes must be paid back. The recapture rate is currently 25%, but it can be higher depending on the tax rate at the time of sale.

## Strategies for Maximizing Depreciation

There are several strategies that commercial real estate investors can use to maximize their depreciation deductions. One strategy is to perform a cost segregation study. This study involves breaking down the components of a property and assigning different useful lives to each component. By doing this, investors can accelerate the depreciation for certain components and increase their overall depreciation deduction.

Another strategy is to take advantage of bonus depreciation. Bonus depreciation allows investors to deduct a percentage of the cost of a property in the first year of ownership. For example, in 2021, investors can deduct 100% of the cost of qualified improvement property in the first year of ownership.

## Conclusion

Depreciation is an essential concept for commercial real estate investors to understand. It can have a significant impact on the profitability of a property and can provide valuable tax benefits. By understanding how depreciation works, investors can make informed decisions about their investments and maximize their returns. It is important to consult with a tax professional to ensure that all depreciation deductions are taken correctly and to avoid any potential issues with the IRS. With the right strategies in place, investors can take advantage of depreciation and improve the overall profitability of their commercial real estate investments. 