Depreciation in commercial real estate is an IRS-approved tax deduction that spreads the cost of a building over its useful life, typically 39 years. It reflects the natural wear and tear of a property, not its market value. For investors, this accounting concept translates into tangible financial benefits: reduced taxable income, stronger after-tax returns, and greater flexibility in portfolio strategy.
Key Takeaways
|
What is Commercial Real Estate Depreciation?
Commercial real estate depreciation allows investors to deduct a portion of a property’s value each year to reflect its gradual wear and tear. It applies to buildings and improvements, not land. Land doesn’t wear out or lose value through use, so it cannot be depreciated.
The IRS sets specific recovery periods under the Modified Accelerated Cost Recovery System (MACRS). Residential properties are depreciated over 27.5 years, while commercial properties follow a 39-year schedule. This system provides predictability for investors and helps shape long-term financial planning. It’s important to remember that depreciation is based on IRS guidelines, not market performance or property appreciation.
Benefits of Commercial Real Estate Depreciation for Investors
Depreciation is one of the most valuable tax tools available to property investors. It creates both short and long-term advantages that directly influence returns and portfolio strategy.
- Tax Savings: Depreciation lowers taxable income each year, reducing the overall tax burden. The resulting savings compound over time, improving net returns.
- Improved Cash Flow: By lowering tax liabilities, investors retain more annual income, money that can be reinvested, used for maintenance, or applied toward debt service.
- Portfolio Planning: Predictable deductions simplify modeling after-tax returns and comparing investment opportunities.
- Leverage in Financing: Improved cash flow enhances an investor’s ability to manage debt and may make an investment more attractive to lenders.
- Long-Term Strategy: Depreciation affects how investors plan dispositions, structure 1031 exchanges, and manage recapture exposure, all key elements of maximizing total returns.
What is the Depreciation Life of Commercial Real Estate?
Under the MACRS system, commercial real estate must be depreciated using the 39-year straight-line method. This means investors deduct an equal portion of the building’s value each year.
However, not every component of a property must follow that same timeline. Certain improvements, such as qualified leasehold or interior improvements, and items like carpeting or equipment, can be depreciated over shorter periods (5, 7, or 15 years). Identifying these items properly can significantly accelerate tax benefits, especially in the early years of ownership.
How to Calculate Depreciation on a Commercial Property
Depreciation can be calculated in three straightforward steps:
Step 1: Determine the depreciable basis.
Start with the property’s purchase price, subtract the land value, and add any eligible improvements or capitalized costs.
Step 2: Apply the recovery period.
For commercial real estate depreciation, divide the adjusted basis by 39 years.
Step 3: Use the straight-line method to calculate the annual deduction.
This provides a consistent deduction every year.
Example: A $2 million building (excluding land) depreciated over 39 years generates roughly $51,000 in annual deductions. Many investors use cost segregation studies to accelerate these deductions, identifying portions of a building that can be depreciated faster. This approach can create substantial early tax savings and stronger short-term cash flow.
What is the Depreciation Rate for Commercial Properties?
The annual depreciation rate for commercial properties under the 39-year straight-line method is approximately 2.56% per year. This provides a consistent and predictable annual write-off, which helps investors plan cash flow and manage long-term tax strategies.
This stable rate makes commercial real estate depreciation a dependable tool for modeling income, assessing investment performance, and planning for future tax obligations.
What is the 80/20 Rule for Depreciation?
The 80/20 rule determines whether a property is classified as residential or commercial for depreciation purposes.
- If 80% or more of a property’s gross income comes from dwelling units, it may qualify as residential rental property and use the shorter 27.5-year schedule.
- If less than 80% of the income comes from dwelling units, the property remains commercial and follows the 39-year schedule.
Example: A mixed-use building with ground-floor retail and upper-level apartments may qualify as residential if most of its income comes from the apartments. Conversely, if the retail component generates the majority of income, it remains commercial.
Correctly applying this rule ensures accurate depreciation schedules and maximizes allowable deductions.
Tax Planning Implications of Depreciation
Depreciation has far-reaching implications for tax and investment strategy.
- Impact on Taxable Income: Depreciation lowers annual taxable income, improving net cash flow.
- Depreciation Recapture: When a property is sold, the IRS may “recapture” depreciation by taxing prior deductions at a rate of up to 25%.
- 1031 Exchanges: Investors can defer both capital gains and depreciation recapture by reinvesting through a 1031 exchange.
Strategically timing sales and exchanges allows investors to manage tax exposure and maintain investment momentum. Depreciation also plays a role in hold-period decisions, portfolio balancing, and long-term disposition planning.
Advanced Strategies: Cost Segregation and Bonus Depreciation
Sophisticated investors often use advanced methods to accelerate depreciation and improve early cash flow.
- Cost Segregation: A cost segregation study breaks down a property into components that can be depreciated over shorter lives, typically 5, 7, or 15 years, instead of the full 39. This front-loads deductions and boosts short-term tax benefits.
- Bonus Depreciation: This incentive allows investors to immediately deduct a large percentage of qualifying assets in the year they’re placed in service. Bonus depreciation is gradually phasing out after 2026, but it remains a valuable tool for maximizing upfront deductions.
Both strategies can provide powerful tax advantages but may increase recapture exposure when selling. For that reason, they should be integrated into a broader, long-term tax and disposition plan.
Getting Started
Understanding the mechanics of depreciation is key to optimizing investment performance. Whether you’re planning to acquire, hold, or sell commercial assets, a thoughtful depreciation strategy can have a measurable impact on cash flow and long-term returns.
Talk with a SIG Advisor to explore how depreciation strategies can influence your portfolio performance, tax planning, and disposition strategy. Connect directly with one of our advisors today.
