# Calculating Cost Recovery for a Residential Property (Example)

Cost recovery, otherwise known as depreciation, is defined as:

1. The periodic allocation of the cost of the portion of an asset that wears out
An allocation of the cost of an asset, taken as an expense against any income that asset produces.
2. The return of investment in business and income-producing property, prorated over its class life.
3. An annual deduction that reduces basis when calculating gain or loss at the time of disposition.
4. Non-cash, tax-deductible expense that reduces taxable income but does not reduce cash flows.

Cost recovery is the primary mechanism through which real estate shelters income and is calculated by multiplying the amount of basis allocated to the improvements of the property by the appropriate cost recovery percentage. The appropriate percentage is determined by the property type which in turn dictates the useful life over which the improvements can be depreciated.

Cost recovery deductions are applied on a straight-line basis, which means that they are constant over the investment’s holding period. Exceptions are made for the year of acquisition and disposition where prorations, determined by the IRS, are applied.

A residential property is purchased on the first day of the tax year for a purchase price of \$500,000 with acquisition costs of \$25,000. The assessed value of the property of the property is \$450,000 with the land being valued at \$90,000 and the improvements at \$360,000. The property is held for 5 years and sold on the last day of the tax year.

Step 1: Calculate the original basis

 Purchase price + Acquisition costs = Original Basis \$     500,000.00 \$                25,000.00 \$      525,000.00

Step 2: Allocation of basis

Because only the improvements are subject to depreciation basis must be allocated.

 Tax Assessment Percentage Basis Allocation Land \$          90,000.00 20% \$       105,000.00 Improvements \$        360,000.00 80% \$       420,000.00 Total \$        450,000.00 100% \$       525,000.00

Step 3: Calculate the cost recovery deduction for the year of acquisition and disposition

Using the table provided by the IRS we multiply the improvement basis by the appropriate percentage. Because it is a residential property that was bought on the first day of the year and sold on the last day of the year 3.485% is used.

 Year-1 Cost Recovery Deduction \$  420,000 x 3.485% = \$  14,637 Year-5 Cost Recovery Deduction \$  420,000 x 3.485% = \$  14,637

Step 4: Calculate the cost recovery deduction for each full year of ownership

Because it is a residential property 3.636% is used.

 Year-2 Cost Recovery Deduction \$  420,000 x 3.636% = \$  15,271 Year-3 Cost Recovery Deduction \$  420,000 x 3.636% = \$  15,271 Year-4 Cost Recovery Deduction \$  420,000 x 3.636% = \$  15,271

Step 5: Calculate the total cost recover taken over the holding period

 Year-1 Cost Recovery Deduction \$  14,637 Year-2 Cost Recovery Deduction \$  15,271 Year-3 Cost Recovery Deduction \$  15,271 Year-4 Cost Recovery Deduction \$  15,271 Year-5 Cost Recovery Deduction \$  14,637 Total \$  75,088

Conclusion: The owner of the property was able to take over \$75,000 in deductions over the 5-year holding period. This amount will need to be deducted from the original basis when the property is sold; resulting in the adjusted basis for the investment which will have implications on the after-tax sale proceeds (discussed in greater detail in subsequent articles).

# What is “Basis?”

In real estate, “basis” is essentially the value of the property for tax purposes. Basis is determined by the method in which the property is acquired. These methods are:

1. Purchase – basis equals the total purchase price of the property plus any capitalized acquisition costs (not financing costs)
2. Inheritance – basis equals the market value of the property at the time of the decedent’s death (regardless of decedent’s basis)
4. Tax-deferred exchange – substitute basis must be calculated to track the non-recognition of gain as a result of the exchange

The basis calculated using these various methods is referred to as original or acquisition basis. For the most common acquisition method (purchase), original basis is calculated by taking the purchase price and adding acquisition costs.

• Property Assumptions
• Purchase price: \$1,000,000
• Acquisition costs: \$50,000
• Original (Acquisition) Basis: \$1,000,000 + \$50,000 = \$1,050,000

Basis is used to determine cost recovery deductions, gain or loss at the time of sale, and amortization deductions. Basis may change over time and can increase or decrease over the holding period of an investment. The most common cause for decreases in basis is due to cost recovery deductions (depreciation) while the most common cause for increases in basis is making capital improvements to a property.

Basis is an important concept for real estate investors and owners to understand. It determines the amount of cost recovery deductions that can be taken which lowers taxable income thereby increasing cash flow after taxes. It also determines the potential gain or loss at the time of disposition which directly impacts the sales proceeds after taxes. Aptly named it forms the basis on which a property’s investment value can be calculated.

# Not Economically Viable: 3 Types of Obsolescence

If you’ve ever seen the movie, Falling Down, with Michael Douglas you may remember the scene where a man who was recently laid off was protesting in front of his former place of business with a sign that read: “Not Economically Viable.”  From the employer’s point of view the gentleman no longer had the skills required to justify his employment. His value to the employer had declined.

This refers to the concept of obsolescence; defined as the state of being which occurs when an object, service, or practice is no longer wanted even though it may still be in good working order. Owners have varying levels of control over the degree to which their properties are affected by the concept of obsolescence, but all real estate is subject to it. This is the primary reason behind cost recovery deductions for real property.

There are 3 types of obsolescence affecting real estate:

1. Functional Obsolescence refers to a decline in value due to its architectural design, building style, size, outdated amenities, local economic conditions and changing technology. The reduction in usefulness or desirability is based on the presupposition that the feature cannot easily or cost-effectively be changed. One example would be a multi-story office building that does not have an elevator.
2. Economic Obsolescence refers to a decline in property due to external factors; meaning that the owner has little to no ability to change the factors that are negatively affecting the property. Examples of economic (sometimes called external) obsolescence can be zoning changes, recession, adverse traffic pattern changes, construction of public nuisance type properties and utilities, i.e. county jails, sewer treatment plants, etc. in close proximity to the property, etc.
3. Physical Obsolescence refers to a decline in property value due to gross mismanagement and physical neglect resulting from deferred maintenance. All real property is subject to physical deterioration over time but the degree to which a property actually deteriorates can be mitigated by the owner. Examples of physical obsolescence include leaking roofs, old HVAC units, old/non-energy efficient windows, etc.

# Annandale Submarket Q4 2018

Several years of negative absorption led to increasing vacancies in Annandale, and levels are now just marginally below the metro average. The submarket lacks large office users, but this presents one benefit—a limited risk of further increase in vacancies. The subpar fundamentals here have kept rents from fully recovering from the recession, with growth wavering between years of gains and losses. Pricing and volume are typically depressed in this locally driven submarket, but volume in 2017 was the highest in years, at more than \$13 million. Sales this year have been relatively strong as well—as of early October, volume was just over \$9 million.

Please click on the links below for detailed information on leasing, rental rates, sales, etc.

# Springfield/Burke Submarket Q4 2018

Vacancies peaked at about 22% following a supply wave from 2011–13 and, despite a subtle recovery, are still extremely high. Rent growth has been weak as a result, and rents remain below the prerecession peak. On a bright note, the submarket experienced a big win when the GSA announced it was moving the Transportation Security Administration’s (TSA) headquarters to Springfield from Pentagon City, a move that will bring 3,400 employees to the submarket and help stabilize fundamentals. Sales have been relatively tame this cycle, with the exception of last year, when more than \$63 million in volume recorded.

Please click on the links below for detailed information on leasing, rental rates, sales, etc.

# Commercial Real Estate 101 – Chapter 3: Rent

A lease abstract is a document that summarizes specific, key information from a lease agreement. Leases can be lengthy documents with confusing legalese. Lease abstracts allow users to easily reference and review fundamental lease terms to ensure that both the tenant and landlord are in compliance with applicable obligations, timeframes, etc.

This series will go through a typical lease abstract and explain the various terms and what is important for a tenant to understand.

Basic Annual Rent

• Tenant’s rental obligation expressed in per square foot terms.
• What’s important – Understanding the rental rate structure, i.e. full service, triple net, etc.

Renewal Rent

• Tenant’s rental obligation expressed in per square foot terms for any renewal terms.
• What’s important – Understanding how the renewal rent will be calculated, i.e. market rate, percentage of market rate, then escalated rent, etc. Provisions may include “greater of” or “lesser of.” Inclusion of objective measure of calculating then market rate, i.e. three broker arbitration.

Rent Abatement/Free Rent

• Amount of time, generally expressed in months, in which tenant shall have beneficial occupancy of the leased premises without having to pay rent.
• What’s important – Rental rate structure. In triple net leases, generally only the basic annual rent abates (tenant is responsible for paying triple net costs and utilities during the rental abatement period). Free rent inside the term vs. outside the term.

Security Deposit

• Amount of money required by landlord to secure tenant’s obligation to pay rent and perform its responsibilities under the lease. Generally expressed in terms of number of months’ rent.
• What’s important – Determined after a review of tenant’s financials. Based on tenant’s financial strength or lack therof, landlord may require multiple months’ rent as a security deposit, in which case burn down provisions may be negotiated. Minimum security deposit is generally one month’s rent.

Late Fee

• Amount charged to tenant for late payment of rent. Generally expressed as a percentage of the amount due.
• What’s important – the amount and timeframe after which tenant is penalized for nonpayment.

Interest

• Rate of interest charged for any overdue payments in addition to other fees.
• What’s important – the interest rate amount, timeframe after which interest accrues, how the rate is determine, i.e. greater of x% or the highest non-usurious rate.

# Depreciation Appreciation: An Overview of Cost Recovery Deductions

Perhaps the greatest benefit to owning real estate is that it can act as a tax shelter for income, and the primary means of doing so occurs through the use of cost recovery deductions. Also known as depreciation, these deductions do not involve an actual outflow of cash but do increase actual cash received by the owner by lowering the property’s taxable income.

Cost recovery is based on the principle that real property declines in value over time through wear and tear, functional obsolescence, etc. Tangible assets are thus accorded a useful life and owners are allowed to write off the asset’s value over that time. For cost recovery purposes, owners must calculate their depreciable basis which is the portion of basis allocated to the property’s improvements (basis is discussed in my article What is Basis).

The useful life of a property is determined by property type: 27.5 years for residential real estate improvements and 39 years for non-residential real estate improvements. Residential properties are defined as properties in which people live for 30 days or more and where no substantial services are provided. This is a key provision because it excludes such property types as healthcare facilities/hospitals where medical service is provided. Commercial or non-residential properties include everything that is not residential, i.e. office buildings, shopping centers, warehouses, etc.

Some notable and interesting distinctions include apartment buildings and mixed-use properties. Apartment buildings, while held for investment purposes and seen as commercial transactions, are considered residential properties for cost recovery purposes. For mixed-use properties, the classification is determined by the source of the gross rental income. If less than 80% of the total income collected is attributed to the residential rental income then the property is considered commercial.

Once the value of the asset/improvements (depreciable basis) and property type have been determined, cost recover deductions are applied on a straight-line basis; meaning they are constant over the investment period. The IRS provides guidelines for determining the percentages in the years of acquisition and disposition.

Cap rates are commonly used to discuss investment value, but often underestimate the an investment’s true return because they do not take into account the benefits of cost recovery. By lowering taxable income and thus increasing real cash flow, cost recovery has the ability to significantly increase yield and is why so many investors have such an appreciation for depreciation.

# You May Be in a Month-to-Month Lease!

In May 2018 there was a significant update in Virginia law that may mean that you’re in a month-to-month lease.

In The Game Place v. Fredericksburg 35, a landlord sued a tenant for unpaid rent on a fifteen (15) year commercial lease.  The landlord prevailed in the Circuit Court, but on appeal, the Supreme Court of Virginia reversed the decision, holding that the lease was unenforceable as a matter of law under the Statute of Conveyances because it was not signed under seal.

The Supreme Court ruled that a lease for a term in excess of five (5) years must, by statute, be by Deed of Lease and must be signed under seal under the common law, which requirements have not been changed by statute.  This made the fifteen (15) year lease a month-to-month lease based on how often the tenant was paying rent, terminable by either side on thirty (30) days’ notice.

If you or your company are currently leasing commercial space for a term of five (5) years or more you should check to ensure that you’re in compliance with the Supreme Court of Virginia’s ruling in this case.

# Route 28 North Submarket Q4 2018

Office – Vacancy in Route 28 Corridor North has lingered above the metro average for most of the cycle, but the spread has thinned this year and is expected to compress further because of the U.S. Customs & Border Protection’s lease for 457,000 SF. Plus, demand has potential to grow here with the eventual expansion of the Silver Line. Deliveries have picked up over the past few years: Of the six properties delivered since 2010, four have come on line since 2015. Furthermore, Google recently purchased 148 acres, where it plans to build a data center, strengthening Loudoun County’s reputation as a key hub for internet traffic. Rents have been among the best performing in the metro over the past five years, and growth so far this year has been the strongest of the cycle. Sales volume in 2015 and 2016 more than doubled and quadrupled the historical average, respectively, but it slowed significantly in 2017 and the first three quarters of 2018.

Industrial – This submarket is best known for the corridor known as Data Center Alley, a stretch along the Dulles Greenway (Route 267) containing one of the largest and fastest-growing concentrations of data centers in the nation. As companies like Amazon, which has another distribution center under construction here, and Google have expanded their needs for server space, the dense node of data centers, along with strong cyclical growth, has made this the busiest submarket for construction in the metro (the next busiest submarket has about one-seventh as much inventory underway). Vacancy rates expanded in early 2016 due to heavy supply hitting the submarket, but strong absorption has since kicked in, and the current rate is at a cyclical low. Relatively little construction this year has helped keep fundamentals on solid footing, but there was more than 7 million SF under construction as of 18Q3, so the supply pipeline is worth monitoring.

Please click on the links below for detailed information on leasing, rental rates, sales, etc.