Applying Real Estate Investment Concepts: Calculating Cost Recovery Deductions

4221 Walney Rd

Cost recovery, otherwise known as depreciation, has many definitions:

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

Source: Financial Analysis for Commercial Investment Real Estate, CCIM Institute

My favorite definition, and the one I believe to be most relevant and easily understood, is the last one. Cost recovery reduces taxable income without reducing cash flows. It’s truly a thing of beauty and is one of the reasons that tax savvy investors love real estate.

I will now show you how cost recovery works in the real world by showing you how to calculate cost recovery deductions over the holding period of an investment for an actual listing that we currently have for sale: 4221 Walney Rd in Chantilly, VA.


4221 Walney Rd

  • Price: $4,250,000
  • Holding Period: 5 years
  • Date of purchase: April 15, 2019
  • Date of sale: April 14, 2024

Step 1: Calculate Original/Acquisition Basis

Assuming a purchase price of $4,250,000 and acquisition costs equal to 3.5% of the purchase price ($148,750), our original basis is $4,398,750.

4221 Walney Rd Basis.png

Step 2: Allocate Basis

You must allocate the basis between the improvements and the land. Cost recovery only applies to the improvements. There are multiple ways to allocate basis but the most common and easily justifiable is by using the ratio used for taxation purposes by the municipality in which the property is located.

The 2019 tax assessed value for 4221 Walney Rd is $4,270,770 with the land valued at $549,400 and the improvements valued at $3,721,370. To find the allocation percentage for the improvements you must divide the value of the land by the total assessed value of the property.

$3,721,370/$4,270,770 = 87%

You then multiply the original basis by this amount.

4221 Walney Rd Basis allocated.png

The allocated basis for the improvements is $3,832,886.41.

Step 3: Determine Property Type and Class Life of Improvements

The IRS determines the class life for residential and non-residential (commercial) properties, which are 27.5 years and 39 years respectively. Because 4221 Walney Rd is an office building we will use the cost recovery percentages for non-residential properties (below).

IRS Cost Recovery Schedule commercial

Step 4: Apply the Straight-Line Cost Recovery Method

Because the property will be purchased on April 15, 2019 we must use 1.819% to indicate the partial year of ownership. We multiply the allocated basis of the improvements ($3,832,886.41) by this percent, which gives us our cost recovery deductions for year-1 of ownership.

4221 Walney Rd Tables year 1.png

This means that your taxable income for the property will be reduced by $69,720.20 in the first year of ownership!

Next calculate the cost recovery for the full years of ownership by following the same process.

4221 Walney Rd Tables full years.png

This means that for each full year of ownership you will be able to reduce your taxable income by $98,275.21!

Finally, calculate the cost recovery deduction for the year of disposition. Because the date of sale if April 14, 2024 you must use 0.749%.

4221 Walney Rd Tables final year

 

Therefore, in the final year of ownership your cost recovery deduction will reduce your taxable income by $28,708.32!


$491,529.35

That’s how much money you will be able to reduce your taxable income by through cost recovery deductions over a 5-year holding period. Because cash flows are unaffected by depreciation, this will result in an increased after-tax return on investment.

For more information and to review the due diligence materials for this property, please contact Ryan Rauner at Ryan@RealMarkets.com or visit our website at http://www.RealMarkets.com.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s