Buildings and land represent substantial investment assets on corporate balance sheets. As an individual taxpayer and property owner, correctly valuing and depreciating buildings and land can help you prepare accurate financial and tax reports.
Depreciation is the reduction of value of a tangible asset, such as a building, machinery or equipment, over a period of time due to normal use and wear.
Depreciation allows you to recover the costs of purchases you make in order to earn income. The IRS publishes a depreciation schedule that tells you how to take the deduction over a specified number of years.
IRS Publication 946 explains how to depreciate property, including buildings (real property). To qualify as a depreciable property, the IRS requires the following conditions be met:
- It must be property you own.
- It must be used in your business or income-producing activity.
- It must have a determinable useful life.
- It must be expected to last more than one year.
The Internal Revenue Service (IRS) allows a taxpayer to recover the cost of non-residential property over 39 years. Residential rental property can be depreciated over 30 years, a reduction from 40 years as a result of the 2018 Tax Cuts and Jobs Act.
The IRS requires that the Modified Accelerated Cost Recovery System (MACRS) be used to depreciate property placed in service after 1986. Under MACRS, there are two depreciation methods for buildings: General Depreciation System and Alternative Depreciation System (ADS).
The General Depreciation System is a declining balance method. ADS offers depreciation over a longer period of time but the deductions are smaller each year. Still, most taxpayers feel that ADS allows for a better match of income versus deductions. Once ADS is elected, taxpayers cannot switch back to the General Depreciation System.
Your basis is the amount of your investment. It includes the cost of the building and the land. When you make improvements to your property, it increases your basis. When you have deductions or casualty losses, your basis is decreased. IRS Pub 551, revised December 2018, guides you in calculating your basis.
Use an online depreciation calculator such as the one available at Calculator Soup to figure out the depreciation expense for your property. The IRS allows taxpayers to calculate their deductions or use the table provided in IRS Pub 946. Calculations on depreciation require the following inputs:
- Cost Basis: The original value of the property
- Recovery Period: The number of years during which the cost basis is recovered
- In-Service Date: The month and year the asset was placed into service
The in-service date assumes the mid-month convention. For tax purposes, it is assumed that the property was put into use halfway through any given month, no matter the actual date the asset was put into service. For example, buildings put into service on May 1 and May 31 would both be considered in service as of May 15.
IRS guidelines and financial accounting rules do not allow land depreciation. Land is considered to have an unlimited useful life. Taking a deduction for depreciation assumes the asset will be used up, obsolete or otherwise be impacted by wear and tear. Such is not the case with land. You may recover the cost of land when you sell the property.
You can take land improvements depreciation if those improvements are closely associated with a building. For example, if land must be cleared and graded to construct or renovate a building, those costs are deductible. If grass, trees and shrubs are planted so close to the building that they would have to be removed if the building were to be replaced, they are considered part of the building with a determined useful life. However, trees planted on the outer perimeter of a property would not have to be removed. They are considered part of the natural landscape, not part of the building, and are therefore not depreciable.