Depreciable Basis is the portion of an asset’s cost that can be depreciated over time. For real property, this usually means the building and certain improvements, not the land. Land is separated because it does not wear out, become obsolete or get used up in the same way a building does.
In simple terms, Depreciable Basis starts with what you paid for the property, then removes the portion allocated to land. Certain capitalized costs may increase the basis, while depreciation deductions reduce the adjusted basis over time.
For real estate, the first step is allocating the purchase price between land and building. A common method is to use the county property tax card, which may show separate assessed values for land and improvements.
Example:
A property is purchased for $100,000. The county tax card values the land at $5,000 and the building at $45,000, for a total assessed value of $50,000. Land represents 10% of the assessed value, and the building represents 90%. Applying those percentages to the purchase price gives $10,000 of land basis and $90,000 of building basis.
The $90,000 building amount is generally the starting point for depreciation. This is different from the full rental property cost basis, because the full basis includes both depreciable and non-depreciable components.
Land is generally not depreciable. The building, however, can usually be depreciated because it is expected to lose value through wear, age and use.
For tax purposes, residential rental buildings are generally depreciated over 27.5 years, while commercial buildings are generally depreciated over 39 years under MACRS depreciation. MACRS stands for the modified accelerated cost recovery system, which is the federal tax system used to recover the cost of many business and investment assets over time.
The relevant depreciation recovery period depends on the type of property and its classification. That classification matters because it determines how quickly deductions may be claimed.
Improvements can increase Depreciable Basis when they add value to the property, extend its useful life or adapt it to a new use. Examples may include a major roof replacement, building expansion, new HVAC system or significant interior renovation.
Routine repairs are different. A repair that keeps the property in ordinary operating condition may be deductible as an expense rather than added to basis. That distinction can be important because capital improvements are recovered over time, while repairs may create a more immediate tax benefit.
Cost segregation studies can also affect timing. A study may identify components of a building that qualify for shorter recovery periods, such as certain five year, seven year or fifteen-year property. That does not necessarily change the total cost of the property, but it can change how quickly portions of the basis are depreciated.
Bonus Depreciation may allow certain qualifying property to be depreciated more quickly, depending on the asset type, placed in service date and applicable law.
Over time, depreciation reduces the property’s adjusted basis. When the property is sold, prior depreciation deductions can affect the taxable gain.
Depreciation Recapture refers to the tax treatment applied to depreciation deductions previously claimed. In a basic example, if a taxpayer bought a property for $300,000, claimed $40,000 of depreciation and sold it for $350,000, the adjusted basis would be $260,000 ($300k -$40k) and the total gain would be $90,000 ($350k – $260k). The depreciation portion may be taxed differently from the remaining capital gain.
Unrecaptured Section 1250 gain generally applies to prior depreciation on real property and may be taxed at a maximum rate of 25%. If a Cost Segregation Study identified shorter life property, some recapture may be taxed at ordinary income rates, making planning especially important before sale.
Original Cost Basis is the total starting investment in the property, including land and building. Depreciable Basis is the portion that may be depreciated, usually the building and certain improvements, after removing the value allocated to land.
A Cost Segregation Study separates building components into different asset classes. It may not change total basis, but it can shift portions of the basis into shorter recovery periods, allowing depreciation deductions to be claimed faster.
Certain acquisition-related closing costs and legal fees may be capitalized into basis if they are directly tied to purchasing the property. The treatment depends on the nature of the cost and whether it relates to land, building or financing.
Bonus Depreciation can accelerate deductions for qualifying property identified within the Depreciable Basis. It generally applies to eligible shorter life assets, not the building itself, so classification and placed in service timing are important.
Inherited property generally receives a stepped-up basis to fair market value at the owner’s date of death. This can reset depreciation calculations for heirs and may reduce or eliminate prior Depreciation Recapture exposure.
For more than four decades, Bennett Thrasher has provided businesses and individuals with strategic business guidance and solutions through professional tax, audit, advisory, and business process outsourcing services. Contact Trey Webb, partner in charge of Bennett Thrasher’s Real Estate and Hospitality Tax Group, or call us at 770.396.2200.
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