An Example of Depreciation, Part 1: Let’s Summarize the Tax Code

Let’s summarize what we’ve been discussing about how depreciation (or cost recovery) can be used by investors to receive a tax deduction each year during ownership of real estate investment property until he or she has written off the entire useful life of the depreciable asset.

1. Depreciation (or cost recovery) forms the basis for a major part of tax shelter and is defined by the tax code as a loss in value to a property over time as the property is being used.
2. The tax code allows the investor to recover a portion of the investment cost irrespective of the actual increase or decrease in value of that asset.
3. Only property held for the purpose of trade or business or for the production of income qualifies for depreciation (not one’s personal residence).
4. Only physical structures (called “improvements”) can be depreciated, not the land (dirt doesn’t depreciate). This is known as the asset’s depreciable basis.
5. Depreciation may be taken on a qualified property when the property is placed into service (when it’s ready for a specified use, usually when title is taken) each year until the entire useful life (not the actual physical life) of the depreciable asset has been written off.
6. Qualified property is classified as residential or nonresidential by the tax code.
7. For tax purposes, the useful life for residential property is 27.5 years, and 39.0 years for nonresidential.
8. The current tax code implements what is called the mid-month convention to determine a date for the month an asset is placed into service and whatever month an investor may dispose of it. In other words, an investor would be get only one-half month’s depreciation deduction for the first month, and only one-half month’s depreciation deduction for the final month.

Next time we’ll give an example calculation. In the meantime, you might want to preview the Proforma Income Statement in ProAPOD Real Estate Investment Software CFA 7.0 and the First-year Investment Analysis Report in ProAPOD Investor 4.0 to see how depreciation influences tax shelter.