Top Commercial Real Estate Terms: Depreciation
It can be very tempting, as a busy investor swamped with much more exciting problems, to simply offload all questions of taxes to your accountant. The most successful commercial real estate ventures, however, are led by those who understand the gritty details, because the more you know, the more you can optimize! One important and valuable concept to understand is depreciation.
What Is It?
Depreciation is a tax deduction. Just like any other deduction for business expenses, the ability to deduct depreciation on a tax return represents the fact that the amount of money a business really makes is only what they have left over after they’ve paid all of the costs of running the business in the first place.
The key thing to understand about the difference between a typical business expense and a depreciation expense is that business expenses are expenses which fit neatly into a single year, since taxes are filed annually. A depreciation expense is one where the cost is paid all at once, but the benefit spreads out over many years. For example, the cost of paying for property management is a business expense, because you pay for it in a given year and receive services that year. On the other hand, if you pay to replace the roof on a property that you own, that roof might last for five or ten years before it needs to be replaced again, so that represents a depreciation expense.
How Do You Use Depreciation?
Whenever you make a large purchase or improvement of a capital asset, such as an upgraded kitchen in a single family home, or a new wing on a commercial structure, or an expensive piece of equipment used for maintenance of a property, you don’t have to apply that entire cost as a business expense in the year it was purchased. Instead, you can determine the estimated useful life of the asset, and divide the expense into multiple years. As a simple example, if you build a $500,000 structure that produces $50,000 annually, it might be very inconvenient for your taxable income on that structure to be -$450,000 in the first year and then the full $50,000 in every subsequent year. Instead, if you suppose that the structure is likely to last for about twenty-five years, you can deduct -$30,000 of the cost each year, decreasing your cost basis in the property by the same amount, for an evenly distributed $20,000 of income on the property annually.
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