Proper understanding and application of depreciation rules can significantly improve the profitability of commercial real estate investments while ensuring compliance with current tax laws.

When it comes to commercial real estate, depreciation is a financial tool that’s often misunderstood but incredibly valuable. 

Unlike other business expenses, depreciation doesn’t involve an out-of-pocket cost. Instead, it allows property owners to deduct the gradual wear and tear of their buildings and equipment over time. For those in the business of property investment and management, understanding depreciation isn’t just helpful - it’s essential to maximizing tax benefits and optimizing returns. Let’s break it down step-by-step.

What Is Commercial Real Estate Depreciation?

Commercial real estate depreciation is a tax deduction designed to account for the declining value of income-producing properties due to wear and tear, aging, or obsolescence. It allows property owners to recover their investment over the asset’s useful life as defined by the IRS.

For most commercial properties, the IRS assigns a recovery period of 39 years. This means that property owners can deduct a fraction of the building’s cost annually over nearly four decades.

Why Does Depreciation Matter?

Depreciation reduces taxable income, leading to substantial tax savings. For example, if a building cost $2 million, you could deduct approximately $51,282 annually ($2 million ÷ 39 years). Over time, these savings add up significantly.

David Cohen, Chairman one one of the commercial real estate attorneys at Cohen Property Law Group (PLLC), explains:
"Depreciation is one of the most effective tools for property owners to maximize returns on their investment while managing tax liability. By leveraging this deduction, owners can preserve more of their income to reinvest in their business or properties."

Key Terms You Should Know

What Property Can Be Depreciated?

Not all properties or assets qualify for depreciation. To be eligible:

1. The property must be used in a business or income-producing activity.
2. It must have a useful life exceeding one year.
3. It must experience wear and tear, deterioration, or obsolescence.

Depreciable Commercial Properties Include:

• Office buildings
• Industrial facilities
• Retail spaces
• Warehouses
• Multifamily rental properties (five or more units)
• Equipment used in conjunction with real estate, such as HVAC systems

What Property Cannot Be Depreciated?

Certain property types are excluded from depreciation because they either don’t have a determinable useful life or are not used for income production.

Examples of Non-Depreciable Assets:

1. Land: Since land doesn’t degrade or lose its utility over time, it cannot be depreciated.
2. Inventory: Items held for resale are not depreciable.
3. Personal-use property: Any part of a property used for personal purposes is excluded from depreciation.

Table: Common Non-Depreciable Items

Method to Depreciate: The Modified Accelerated Cost Recovery System (MACRS)

he Modified Accelerated Cost Recovery System (MACRS) is the principal method of depreciation used for most commercial real estate and equipment in the United States. 

Implemented by the IRS, MACRS allows property owners to recover the cost of qualifying assets over a specified useful life, as determined by the asset's classification. This system is divided into two primary approaches: the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). MACRS Components:

1. General Depreciation System (GDS): GDS is the default option and provides faster depreciation through methods such as the double-declining balance, which accelerates deductions in the earlier years of an asset’s life.
2. Alternative Depreciation System (ADS): ADS, typically required for certain types of property like tax-exempt assets or those used predominantly outside the United States, uses the straight-line method for more gradual depreciation over a longer recovery period

Key MACRS Conventions:

Key conventions within MACRS, such as the half-year convention - assuming assets are placed in service halfway through the year - or the mid-month convention - specific to real estate - further refine how depreciation is calculated. 

For example, commercial buildings under GDS are depreciated over 39 years, while shorter-lived assets like furniture or equipment may use a 5- or 7-year recovery period. The flexibility of MACRS in accommodating varying asset classes and recovery schedules makes it a critical tool for commercial property owners seeking to optimize tax benefits and manage cash flow effectively.

• Half-Year Convention: Assumes all property is placed in service mid-year, allowing for half a year’s depreciation in the first and last years.
• Mid-Month Convention: Used for real property, starting depreciation in the middle of the month the property was placed in service.

What Is the Basis of Your Depreciable Property?

The basis of your depreciable property is a fundamental value that determines the starting point for calculating depreciation deductions. 

It is essentially the cost of acquiring the property, adjusted by additional costs or reductions incurred over time. 

Components of the Initial Basis

1. Purchase Price: This includes the amount paid to acquire the property, whether paid in cash, through debt, or in exchange for other property.
2. Closing Costs: Expenses incurred during the acquisition process, such as:
   • Legal and recording fees
   • Title insurance
   • Surveys and appraisals
   • Real estate agent commissions
3. Improvements Made During Acquisition: These include costs associated with making the property ready for use, such as renovations, structural additions, or utility installations.

Adjustments to Basis

The basis of a property doesn’t remain static - it must be adjusted over time based on certain events or transactions. Adjustments can either increase or decrease the basis:

• Increases to Basis:
  • Costs of major improvements that enhance the property’s value or extend its useful life (e.g., a new roof, structural expansions, or HVAC upgrades).
  • Assessments for local improvements, such as sidewalks or sewer lines.
  • Legal fees related to defending or perfecting the title.
  • Any additions to the property made after purchase.
• Decreases to Basis:
  • Depreciation deductions claimed or allowable over the life of the property.
  • Casualty losses, such as damage due to natural disasters, for which deductions were claimed.
  • Insurance reimbursements for losses or repairs.
  • Tax credits or rebates received, such as energy efficiency incentives.

Example of Basis Calculation

Imagine you purchase a commercial office building for $1,500,000. At closing, you pay $20,000 in legal fees and $10,000 in title insurance, bringing your total initial basis to $1,530,000. If you later invest $50,000 in renovations, such as upgrading the HVAC system, your basis increases to $1,580,000. Over the next three years, you claim $120,000 in depreciation deductions, reducing your adjusted basis to $1,460,000.

Special Situations in Basis Calculation

1. Inherited Property: The basis is generally the fair market value (FMV) of the property at the time of the decedent’s death.
2. Property Changed from Personal to Business Use: The basis is the lesser of the adjusted basis or the FMV of the property at the time of the change.
3. Like-Kind Exchanges: For properties acquired in like-kind exchanges, the basis is generally carried over from the relinquished property with adjustments for cash paid or received.
4. Constructed Property: If you build the property, the basis includes construction costs such as materials, labor, and permits.

Why the Basis Matters

The basis determines not only the annual depreciation deductions you can claim but also the gain or loss when the property is sold or exchanged. Accurate basis calculations ensure compliance with tax laws and maximize the financial benefits of owning commercial real estate.

Important Sections That You Need To Know: Section 179

Section 179 Deduction and Bonus Depreciation are two powerful tax incentives that allow commercial property owners and investors to recover the cost of property improvements and tangible assets more quickly. These provisions help reduce taxable income and improve cash flow, making them essential tools for real estate investment and development.

What is Section 179?

The Section 179 Deduction allows businesses to immediately expense the cost of qualifying property instead of depreciating it over multiple years. This can apply to tangible personal property and some real property improvements, providing significant tax savings in the year the property is placed in service.

The maximum deduction has been increased to $1,220,000, an increase from the 2023 limit of $1,160,000. However, this benefit phases out dollar-for-dollar once total purchases exceed $3,050,000, up from the previous year’s threshold of $2,890,000. Businesses making purchases exceeding $4,270,000 will no longer be eligible for the Section 179 Deduction.

What Is Bonus Depreciation?

Bonus Depreciation allows taxpayers to take an accelerated deduction for a percentage of the cost of qualifying property in the first year it is placed in service. Unlike Section 179, there is no annual limit or phase-out threshold for Bonus Depreciation, and it applies to both new and used property.

Actionable Tips for Taxpayers:

1. Utilize Section 179 for smaller improvements or equipment in 2024, especially as limits rise.
2. For long-term planning, consider the phase-out of Bonus Depreciation and its impact on property acquisition strategies.

Final Remarks

Depreciation remains one of the most effective tools in commercial real estate for reducing taxable income and improving cash flow. From Section 179 deductions to Bonus Depreciation and the Modified Accelerated Cost Recovery System (MACRS), these provisions empower property owners to recover the costs of wear and tear over time—or in some cases, immediately.