Summary:

Depreciation also considers tax deductibility for property owners, serving as a perceived benefit. Taxpayers are allowed to recover the natural deterioration of the structures over time. The Internal Revenue Service (IRS) allows straight-line depreciation of 27.5 years for residential rental properties and 39 years for commercial properties. The problem is that the concept of recapture negates the benefit. When the seller finally sells their investment real estate, accrued depreciation over a long period must be classified as ordinary income and taxed at those rates.

Unveiling the Significance of Book Depreciation as a Method of Tax Deferral, Often Dubbed as Tax Avoidance.

Article:

We must differentiate between depreciation as a tax issue and real depreciation as a building wears out over time.

·Physical Deterioration:

·Curable- Things that can be corrected reasonably, such as deferred maintenance, wear and tear, cracks, paint, roofing, dry rot, and infestation.

·Incurable- Things that cannot be practically or economically corrected, such as settling a building or structure, or when the property is old and too worn out that repairing it is not financially practical.

·Functional Obsolescence:

·Curable design defects and outdated buildings.

·Incurable deficiencies that are not practically fixed, such as retail and office buildings lacking off-site parking, apartments without garages, or with less-than-adequate parking.

·Economic Obsolescence:

·Issue caused by negative influence outside the site. Examples include zoning changes, the business district moving away, freeway offramps nearby, and the employment base changing or eliminating.

·Book depreciation:

·Accounting terminology referring to the owner’s tax efforts to recapture the investment by writing off the physical structures. Also, depreciating the associated business personal property is used. Owners attempt to reduce taxable income through what is referred to as “tax incentive Investments.” When used strategically, these tax incentives can significantly mitigate the impact of book depreciation on a property's value.

Here are a few actual examples that I have encountered while dealing with depreciation:

Physically curable: When assessing upgrading of a property, the cost usually makes economic sense to fix up rather than replace the structure. An entire industry based upon the concept is called the fix-and-flip industry. Fix-ups are common because all properties physically deteriorate over time and need a facelift.

Physical incurable: When evaluating the extent of damage to a property, there becomes a magic point where the cost to cure will exceed the added value based upon the upgrades. At this point, the decision to do massive rehab or tear down and rebuild becomes the discussion. My company once made a loan on the Dana Villa Motel in Dana Point, California. The property was built in 1928 when Dana Point was first subdivided into a beach community. It was located on Pacific Coast Highway, close to the shoreline of Doheny State Beach. Remember the song, Surfer Joe by the Surfaris. “Down in Doheny were the surfers all going, there’s a big blonde, named Surfer Joe.”

The borrower defaulted, and eventually the property was foreclosed upon. What do you do with a picturesque Spanish stucco and tile roof, with a backdrop of the Pacific Ocean? We immediately sold it to a new opportunistic developer who had his vision about the future of this property. After multiple construction bids, a test for dry rot, a water table study, and interaction with the city planning department, it is evident that it would cost as much to fix it up as demolishing and building a new building. It took a while because the old surfer bums in the community wanted it rehabilitated, so that they could drive by and romanticize about their youth, and days gone by. Their opinion was to restore the original beauty to satisfy them, even though it would have been an economic catastrophe. I took the heat, obtained a permit, and demolished the pile of junk over a weekend. Problem solved!

A further example is a property owner who owns a duplex constructed initially in the 1970s. In 2010, the decision had to be made whether to rehab or demolish and reconstruct a new building. In the 1970s, the city zoning ordinance allowed four units per 4000 sq ft lot. Later, a downzoning only allowed two units per 4000 sq ft. Later, another downzoning occurred, allowing only 1 unit per 4000 sq ft. The city kept a provision for rehabilitating property by taking it down to the frame and then starting on the reconstruction. The decision was to build a new modern duplex with a much better floor plan and panoramic ocean views. One lowly wall was left to satisfy the city's requirement. Later, I heard that the wall somehow disappeared and was replaced when the insulation and drywall were installed. The result was an economically more feasible modern building with much higher rent.

Curable design defects: Millions of homes were built post WWII between 1000 and 1500 square feet, and row homes in symmetrical neighborhoods were designed for middle-class family expansion during the 1950s and 60s. The houses generally had a small kitchen, dining room, and small living room intended for separateness. Lots were typically large enough for add-on rooms and patios.

The segregated feeling of small rooms has now been changed to “open concept floor plans” with fewer walls and sitting-level kitchen countertops, giving the sense of a bigger home where all the family can gather together in a larger space. By reconfiguring the floor plan and adding modern appliances and equipment, the owner can revitalize the economic viability of the home and make it more livable. The renovation was cost-effective and updated to a contemporary feeling.

An income property built around 1970 had a kitchen separated with Formica counter tops, and ceiling-hung cabinets designed to hold dishes and glasses. It made the room feel small and crowded. The sink was placed against a blank wall. The whole kitchen felt like a dark and dank bad dream. Replacing the countertops, removing the ceiling cabinets, and relocating the sink under a window opened the room! The kitchen and living area were combined by installing a small island with storage cabinets below. The kitchen went from dark and dank to bright and new!

Incurable Design defects are a much more complex subject because they are known, but there is no practical or cost-effective method to fix them. Examples include residential rentals and commercial units built with little or no on-site parking, low ceiling heights for industrial buildings, and a lack of dock heights in industrial buildings. Understanding and managing these incurable design defects is a key part of property management and can make a property owner feel more prepared and knowledgeable.

Economic Obsolescence: How many remember Route 66? I came to California from Arkansas in 1954 in a 1950 Chevy pick-up truck, six-cylinder, three-speed on the floor with no air-conditioning, which made crossing the Arizona/California desert at 110-degree heat a not-so-enjoyable drive.

Route 66 is reflected in history books and revisited by people like me for cultural remembrance. Chuck Berry, Nat King Cole, and others sang “Well, if you ever plan to motor west, Jack, take my way, it's the highway, that's the best. Get your kicks on Route 66. Well, it winds from Chicago to L.A. More than two thousand miles all the way- Get your kicks on Route 66.” All the business, commercial, retail, and many residential buildings were displaced by the new “grand highway,” leaving Route 66 behind in the dust. If you were politically powerful, you could redirect growth toward your property. If you were just a hard-working stiff and family man, oh well?

Commercial retail properties with one source of ingress/egress are problematic. Also, residential properties built in a neighborhood, but now backed up to a freeway or busy street, will be valued less than those unaffected.

Book depreciation: Current depreciation schedules are referred to as straight line over 27.5 and 39 years. If you have a piece of investment property, you will separate the land value from the physical structure. Only physical structures and associated business personal property can be depreciated for federal and state tax purposes. The tax advantage is now marginal at best. Many of us remember double declining depreciation over 15 years, and 125% declining balance over 15 years. You will need an expert accountant for this subject.