Cost recovery, otherwise known as depreciation, has many definitions:
- 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/useful life
- An annual deduction that reduces basis when calculating gain or loss at the time of disposition, or
- 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.
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.
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).
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.
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.
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%.
Therefore, in the final year of ownership your cost recovery deduction will reduce your taxable income by $28,708.32!
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.