Because commercial real estate is considered an asset rather than an expense, the Internal Revenue Service won't let you write off its cost in the year you buy it. Instead, the agency requires you to decrease its value every year by a small amount to simulate its gradual loss of value as it deteriorates. This process is called depreciation. Most commercial buildings have a 39-year life, although you can speed up the process and claim your depreciation in less time.
Commercial Buildings and Land
Commercial buildings are depreciated over 39 years. Commercial land, on the other hand, is not depreciable, because the IRS looks at land as something that doesn't deteriorate over time. Since you usually buy buildings and land together, you will need to allocate the value that you pay for the property between the building and land. It's best to get an accountant's advice on how to do this in a way that both maximizes your depreciation while also being able to pass muster with the IRS. If you make improvements to land so you can place a building on it, those improvements are depreciable over 15 years.
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When you build out space for a tenant, the IRS lets you depreciate those "leasehold improvements" over 15 years instead of 39 years. This is because you usually have to undo and redo leasehold improvements every time a tenant moves out, so the improvements don't last as long as your building. The improvements must be completely inside the tenant space and should be nonstructural. In addition to the accelerated 15-year depreciation, you can write off the entire balance of the leasehold improvements in one lump sum if the tenant moves out before the end of the 15 years. The 15-year timetable has been a part of the law since 2004 but requires periodic congressional approval. Confirm with your accountant to ensure the timetable is still in effect.
One way to accelerate your depreciation is through cost segregation. This allows you to divide your building into all of its constituent systems, some of which have a life that is much shorter than 30 years. For instance, if your building has a computerized security system, you could write off the computers in the security system over a five-year period. This moves a lot of your depreciation to the front of the depreciation schedule -- earlier in your ownership of the building -- and saves you money in the beginning. But by taking more depreciation up front, you have less depreciation to claim in the future.
Depreciation and Taxes
Depreciation offsets income from your rental property on a dollar-for-dollar basis. For example, if you have $100,000 of income and $30,000 in depreciation, your taxable income becomes $70,000. If you're paying a 33 percent marginal tax rate, that would reduce your tax liability by $10,000. However, if you sell your building for more than its cost minus all the depreciation you claimed, the IRS will see that the building didn't really lose value like it was supposed to based on your depreciation. In that instance, the agency would charge you a depreciation recapture tax, also known as a section 1250 tax, of 25 percent. Taking the above example, if you claimed $30,000 depreciation and the building that you bought for $1 million sold for $1 million, the IRS would charge $7,500 in depreciation recapture tax when you sell.