Real estate is at the heart of modern-day economic activities, as the sector remains the financial engine in most developed countries. Depreciation encourages building owners to engage in development activities and invest substantial resources in long-term projects. Corporate accountants record building-depreciation transactions in accordance with U.S. generally accepted accounting standards and Internal Revenue Service directives.
Building depreciation is a practice that enables a real estate owner to allocate the property's cost over many years, typically over its useful life. Useful life is the length of time the building will serve in operating activities. Buildings are considered long-term assets because they most likely will serve in operating activities for more than 12 months. U.S. GAAP and IRS guidelines allow companies to depreciate buildings with a straight-line method, which requires the same depreciation amount every year. In contrast, an accelerated method of depreciation allocates higher costs in earlier years.
Depreciation is an important economic incentive that allows building owners and real estate industry executives to reduce their fiscal liabilities, according to the American Institute of Professional Bookkeepers. Without these incentives, the industry may experience a reduced level of economic activity.
The IRS requires that accountants depreciate residential buildings with a straight-line method over 27.5 years. For example, an investor buys a building near a university and intends to rent it to out-of-state college students. The building is worth $27.5 million. As a result, the depreciation expense for the first year equals $1 million ($27.5 million divided by 27.5). To record the expense, a corporate accountant debits the depreciation expense account for $1 million and credits the accumulated depreciation account for the same amount.
Under U.S. GAAP and IRS rules, a company must depreciate a commercial property over 39 years. For instance, an insurance company builds an office complex in the New York City metropolitan area. Construction costs amounted to $78 million. The annual depreciation expense equals $2 million ($78 million divided by 39). To record the expense, a corporate accountant debits the depreciation expense for $2 million and credits the accumulated depreciation account for the same amount.
Depreciation enables building owners to reap two types of benefits — they do not pay for depreciation expense, but they pay lower taxes. Indeed, companies do not disburse cash in depreciation activities, unlike other general or factory expenses, such as rent, labor charges, insurance and office supplies. This double-benefit incentive is key to long-term asset purchases, as it encourages companies to invest substantial amounts in expansion programs, such as mergers and acquisitions as well as plant renovations.