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.