Because depreciation (or cost recovery) forms the basis for a major part of tax shelter, realtors that work with with real estate investment property and those investing in real estate for renting should understand something about depreciation.

Depreciation (cost recovery) is defined by the tax code as a loss in value to a property over time as the property is being used. In other words, because physical structures (called “improvements”) do wear out, the government (according to rules specified in the tax code) allows property owners to take a tax deduction each year until the entire depreciable asset is written off.

The amount of depreciation deduction is based on the rental property’s useful life (the term used for tax purposes) and not nessarily the actual physical life expectancy of the physical asset. For example, let’s assume the Great Pyramid was built as an apartment complex subject to our current tax code. The owner would not have been able to depreciate it over the the thousands of years it has actually physically endured, but only over its “useful life” as prescribed by the code. (An absurd example, of course, but you get the point).

For a property to be eligible for depreciation, the real estate property must be used in a trade or business or held for the production of income. So an individual’s personal residence does not qualify for depreciation deductions. Moreover, it must be something that wears out or loses its value from natural causes. Therefore only the physical structure and not the land can be depreciated. For example, if you purchase a ten unit apartment complex for $700,000, of which you attribute $490,000 to the building and $210,000 to the land, you can only depreciate $490,000 and not the full $700,000.

Summary

1. The tax code permits depreciation deduction for income property (not one’s personal residence)
2. The useful life (not the physical life expectancy of the asset) becomes the depreciable basis
3. Only physical structures (not land) can be depreciated

We’ll continue to explore depreciation next time. Stay tuned.

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