The following Q&A was completed as part of our conversational Commercial Real Estate FAQ Interview Series, we hope you find it helpful.
While many think of depreciation as a cash concept, it’s actually a tax concept. For a commercial building or residential property, a building will depreciate as years go on and the building grows closer to obsolescence. This captures the cost of having to replace or upgrade the building over time. What you save on depreciation values on your taxes each year, one may want to put away to cover these cash costs to upgrade as required later down the line.
What is depreciation and why does it matter? So, Richard, depreciation is an accounting concept more than a cash concept. And what that means is it really has to do with how you think about a property or an investment on your tax return, meaning what are the tax consequences of owning real estate or buying a piece of equipment. And so depreciation is really a very simple concept. What it is is its obsolescence of something. So, over time, let’s say you purchase a truck, a moving truck for your moving company – well, that moving truck, it’s going to get beat up, it’s going to get old, it’s going to become basically obsolete, right? Over maybe 10 or 15 years. And you could say the same for a building. Now, a building isn’t going to get obsolete in 5 or 10 years, but over the course of 20, 30, 40 years, you could see that a building would. In fact the structure itself, not the land, but the structure would diminish in value and the accounting for that on your tax return and trying to capture that cost of eventually having to replace that building or upgrade it is captured in the concept of depreciation.
And so commercial and residential building assets can be depreciated either over 39 years, or for residential property 27 and a half is the last tax code that I recall. So, basically that means that if you have a $100,000 building that you built on a $50,000 piece of land, you divide $100,000 by 39 years and every year you would have 1/39 of that, which – let me do out the math real quick – so basically you’d have 1 over 39, on commercial is 2.5% a year times 100,000 would be roughly $2,500. So that would be your annual depreciation costs, and so the idea is that the building is losing $2,500 worth of value every year so that gets captured. And you get an expense for that; you get to expense that on your tax return, so you don’t have to pay taxes on $2,500 worth of income that particular year.
It’s a little bit faster for residential properties, like I said, it’s 27 and a half when I looked it up here. That may by outdated, but that’s the last that I knew. So, depreciation, it’s a tax concept, it’s not a cash expense, it’s a tax expense. But it’s good to set aside money every year to cover the cost of your depreciation, to set aside actual cash because, you know what? That building will be obsolete, and if you do hold it for 20 or 30 years you are going to have to replace it or upgrade it, so it’s a good idea to have set asides to cover the actual depreciation. But depreciation itself, is a tax concept. Hopefully that helps.