At a Glance —
- An often overlooked but significant advantage of commercial real estate investment is the tax benefit of depreciation
- Your taxable income is reduced by your portion of a CRE investment property’s annual depreciation expenses
- Cash flow generated by CRE investments can be offset, or even eliminated, by your portion of the depreciation
- You will need to deal with depreciation recapture upon liquidation of the investment property, but the prior annual tax savings will outweigh the recapture tax
When you invest in commercial real estate, you expect cash flow as well as long term asset appreciation. However, a significant advantage of investing in CRE is the potential tax benefit which conveys to investors, allowing them to reduce or defer taxes annually as a result of the tax laws for depreciation.
Depreciation is defined as a reduction in the value of an asset with the passage of time, due to wear and tear. It is a non-cash expense and the IRS defines it as ‘an annual income tax deduction which allows you to recover the cost or other basis of certain property, over time’.
In the current tax code, CRE investors can deduct their portion of a property’s annual depreciation expense from their taxable income. The IRS determines the useful life — or, the expected operating life — of a commercial real estate property. The current tax code typically allows investors to reduce the value of their portion of the investment property in equal installments over a period of 39 years. This defined ‘useful life’ of the property does not include the land value, only the buildings and any capital improvements.
Depreciation may be a significant benefit if you are seeking to reduce your total taxable income. Your portion of the depreciation in a CRE investment is treated as a write off against ordinary income. Essentially, the amount of tax paid on the annual cash flow generated from your investment is potentially reduced, or even eliminated, by your portion of the depreciation.The bonus here is that during the time you hold the investment — and generate cash flow, and save on taxes — the value of the investment property is actually still appreciating.
When the investment property is sold, investors will likely have to deal with depreciation recapture. Meaning you will owe taxes on the amount you depreciated while you held the investment but generally the tax rate for depreciation recapture typically has been lower than the income tax rate. The amount you save in taxes each year with the depreciation tax deduction will outweigh the taxes owed for depreciation recapture.