Depreciation (Cost Recovery)
Depreciation or cost recovery forms the basis for a major part of an investor’s tax shelter on a real estate investment.
Defined as a loss in value to a property over time as the property is being used, depreciation is difficult to visualize because most real estate investments appreciate over time (gain value). The more recent term “cost recovery” is better. It implies that the real estate investor can recover a portion of the investment cost, regardless whether the investment property increases or decreases in value.
To be eligible for depreciation, the investment property must be used in a trade or business or held for the production of income, have a useful life longer than a year, and must be something that wears out or losses value from natural causes.
Depreciation for real estate investment property may be taken when the property is placed in service for a specified use, even if it is not immediately used for the intended purpose. An entire apartment complex with several vacancies, for instance, would qualify for cost recovery because the units (though not fully occupied) are ready and available for use. A newly constructed apartment complex is considered placed into service when a certificate of occupancy is granted.
Calculating Depreciation (Cost Recovery)
Depreciation deductions are calculated in the following manner. There are essentially four parts to the equation.
1. Basis – This is typically the original cost of the property plus capitalized costs of acquisition such as broker’s fees, appraisal fees, survey fees, title insurance, etc. As the investment is depreciated, the original basis minus accumulated depreciation results in an adjusted basis.
2. Depreciable Basis (Cost Recovery Basis) - This is the overall basis minus the value of land. A $300,000 duplex with $100,000 attributable to land, for instance, would have a depreciable basis (cost recovery basis) of $200,000.
3. Class and Cost Recovery Period – This determines the investment property’s class and appropriate recovery period. A property is classified as “residential” if 80% or more of the gross income is derived from dwelling units and is depreciated over 27.5 years. Other investment property is classified as “nonresidential” and is depreciated over 39.0 years.
4. Date Placed in Service – This is the date the property is placed in service. It determines the amount of first-year depreciation and the amounts for all future years in the holding period.
ProAPOD users should be aware that our Real Estate Investment Software (10.0) and Real Estate Investor Software (4.0) each make calculations for depreciation (cost recovery). Moreover, each software solution computes the depreciation for residential (27.5 year) and nonresidential (39.0 year) real estate investment property.
