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 accordingly.

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

Article:

We must distinguish between depreciation as a tax issue and real depreciation, which occurs 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·Curable design defects and outdated buildings.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 relocating, freeway off-ramps nearby, and changes to or elimination of the employment base.

·Book depreciation:

·Accounting terminology referring to the owner’s tax efforts to recapture the investment by writing off the physical structures.  Additionally, depreciation of the associated business personal property is utilized.  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 the upgrading of a property, the cost usually makes economic sense to repair rather than replace the structure.  An entire industry based on this concept is known as 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 undertaken to either massively rehabilitate or tear down and rebuild becomes the topic of 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, set against the 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 would cost as much to repair the existing building as it would to demolish and rebuild a new one.  It took a while because the old surfers in the community wanted it rehabilitated, so they could drive by and romanticize about their youth and days gone by.  Their opinion was to restore the original beauty, even though it would have been an economic catastrophe.  I took the heat, obtained a permit, and demolished the pile of junk over the 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 rehabilitate or demolish and reconstruct a new building: In the 1970s, the city zoning ordinance allowed four units per 44,000 sq ft lot.  Later, a downzoning was allowed for units per 4,000 sq ft.  Later, another downzoning occurred, allowing only 1 unit per 4000 sq ft. The city maintained a provision for rehabilitation properties by taking them down to the frame and beginning the reconstruction.  The decision was to build a new, modern duplex with a significantly improved floor plan and panoramic ocean views. One low 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, ranging from 1,000 to 1,500 square feet, and row homes in symmetrical neighborhoods were designed for middle-class family expansion during the 1950s and 1960s.  The houses generally had a small kitchen, dining room, and a large living room intended for separation.  Lots were typically large enough for add-on rooms and patios.

The previously segregated feeling of small rooms has now been replaced with “open concept floor plans,” characterized by fewer walls and sitting-level kitchen countertops, creating the sense of a larger home where the entire family can gather together in a single, spacious area. By reconfiguring the floor plan and incorporating modern appliances and equipment, the owner can revitalize the home’s economic viability 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 with a Formica countertop 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 up the roof! 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 in industrial buildings, and inadequate dock heights in industrial buildings.   Understanding and managing these incurable design defects is a crucial part of property management, as it 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 pickup truck, a six-cylinder, three-speed-on-the-floor model 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.   hHHuckBerryat 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 6.  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 proper y. If you were just a hard-working stiff and family man, oh well?

Commercial retail properties with a single point of ingress/egress are problematic.  Additionally, 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 the straight-line method 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 refer to double-declining depreciation as a 1-year and 5% declining balance over 15 years.  You will need an expert accountant for this subject.