Why is depreciation 1/27.5?

Question

Can anyone who has owned a property for a long period of time confirm that the money they spend over 27.5 years is approximately the original cost of the structure?

Is this supposed to be maintenance, or are capital expenses included? Don't we already deduct maintenance costs from our rental income, and depreciate large expenditures separately? So why do we get this additional tax benefit? (I am aware that you have to recapture the depreciation when you sell, but why does it exist in the first place?)

My rental property is a condo, which means technically I don't own any land. In fact, the city assesses $0 for my land value, and the total assessment is all classified as building. So I have been using my entire purchase price as my cost basis. It seems I have a tax advantage over a similar valued single family house, no?

Dave Toelkes · Answer

@Paul B.

Your understanding of depreciation is incorrect.  Depreciation is a tax code device that allows one to recover the original cost of a depreciating asset over a finite length of time.

If I buy a rental property with a depreciation basis of 100K, then I am allowed to take a tax deduction (called depreciation) for the investment cost of the property prorated over the next 27.5 years that the rental property is in service.  After 27.5 years, my depreciation deductions will total the full cost of the depreciable asset.

The money you spend in maintenance and upkeep is a separate expense deduction in addition to the depreciation expense.

The residential rental property depreciation schedule is 27.5 years because that is the class life of residential rental property established by congress and implemented by the tax code.  In a future session of Congress, tax legislation could change the length of the depreciation schedule for property placed in service after the implementation date of the new legislation.

Roy N. · Answer

Dimitri:

Not quite ... depreciation is calculated using a declining balance methodology.  The residual balance at the end of the first year is the starting value for the next year, so you get 4% of a smaller capital value each year (not 4% of the original value)  If you buy a 100K property, and chose to claim Capital Cost Allowance  (the taxman's term for depreciation), then you have:

• Year 0:     100,000
• Year 1:     96,000
• Year 2:     92,1260
• Year 3:     88,474
• Year 4:     84,935
• ....
• Year 10:    66,484
• ...
• Year 25:    36,040
• ....
• Year 35:    23,960
• ....
• Year 50:    12,989

Paul B. · Answer

I've read that in Japan, houses are usually torn down after about 30 years, which means the 27.5 year useful life is fairly accurate if we followed the same practice here. But the same article says that in the US the average house is not demolished until 100 years.

http://freakonomics.com/2014/02/27/why-are-japanese-homes-disposable-a-new-freakonomics-radio-podcast-3/

Dmitri L. · Answer

Oh I see! Thanks for explaining. I think this approach is much better than straight line depreciation. A building will "lose" more of its value in its first 10 years, compared to its last 10 years. This approach should be a much better approximation of reality.

Dmitri L. · Answer

Actually wood frame structures are depreciated over 22 years on Japan taxes. The rules get even funnier for used buildings, to the point that if you buy a wood building over 22 years old, you can depreciate it over 4 years give or take

4% rule for Canada is interesting. It's really the same thing as saying 25 year useful life, but doesn't carry the same subtext of - the building will be worthless in year 26..

Roy N. · Answer

@Sebastien Hitier

And countries like Canada set a depreciation for most building types at 4%/annum.

Sebastien Hitier · Answer

Other countries like Japan Tax have depreciation over 46 years for reinforced concrete structure buildings and 26 year for wooden frame. One could argue for slower depreciation for brick buildings than wooden framed ones. US IRS made the simple choice, allowing a 27.5 years depreciation.

You might want to check out this website to get the right depreciation number: http://www.investor-realestate-accounts.com/, it is 1/27.5 if the property was in service for the full year. If purchase or sale occured on a given month in the year, the house is asusmed to be for half of that month.

Cameron Skinner · Answer

When you buy a piece of equipment or a car for your business irs dose not allow you to expense it all in the first year because it is an asset not an expense.  Depreciation is just a way of you to expense a business asset as it wears out over time.  Irs allows you to depreciate a car over five years we all know It can last much more than that especially if you maintain it.  Accelerated depreciation has always been a tool by the government to encourage people to invest in equipment and even real estate.  It even used to be more lucrative back before 1984 tax act.

Homes like anything else wear out and the structure will eventually become worthless.  Unless you completely remodel the home and then new depreciation starts on value of the remodel.  Homes tend to increase in value even as the actual structure goes down in value this is because of inflation.  Try selling a similar size home that was built in the 50s and has never been remodeled compared to a brand-new home.

Hope this helps good luck

Chris Soignier · Answer

Don't try rationalizing IRS guidelines for how long you can depreciate buildings over - it won't accomplish anything aside from perhaps giving you a headache.   Just learn the rules, and learn to use them to your best advantage.  I don't stop for a second to think about IRS rationale for various rules - I have no power to influence them, so I just want to get maximum benefit from their rules and regs.

You depreciate the cost basis, which includes your purchase price plus capital expenditures - and diff. parts/systems can have different depreciation schedules if you choose to adopt accelerated depreciation.   Maintenance is expensed in the period incurred, and neither added to the cost basis nor depreciated.

In a condo, you typically own an undivided interest in the common areas, plus the air space between your walls.    I'm no expert in condos, but your tax assessment feels wrong to me.    If you did have a tax advantage over a SFR, it would be more than offset by the condo fees.

Why is depreciation 1/27.5?

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