Cost recovery, otherwise known as depreciation, is defined as:
- 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. - The return of investment in business and income-producing property, prorated over its class life.
- An annual deduction that reduces basis when calculating gain or loss at the time of disposition.
- 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).
