By Christina S. Porter
One of the more significant benefits of investing in income-producing real estate is the ability to decrease the tax obligation on the income produced through depreciation, also known as cost recovery. Depreciation is defined as the recovery of the acquisition costs of IRS Section 1231 tangible assets, such as real and personal property.

When a property is purchased, a tax basis is allocated to the depreciable and non depreciable portions — the depreciable portion being the building improvements, and the nondepreciable portion, which is the land.

In the tax records there is usually a percentage of the property assigned to improvements — meaning the building — which is the depreciable portion. However, those records are frequently inaccurate and must be verified. Once the correct percentage of the property is identified, a tax basis can be calculated by multiplying the percentage given and the purchase price of the asset. For example: The purchase price is $1 million and the percentage of improvements is 5 percent and the tax basis is $750,000.

Depreciating an asset reduces the taxable income and increases after-tax cash flow. Theoretically, the depreciation corresponds with the amount of expected wear and tear, and potential obsolescence during the tax life of a property, presumably making the tax basis in the property at the time of disposition equal to the market value of the property at the time of sale.

There are different methods used to depreciate a property — one of which will be designated at the time of the purchase. The straight line cost recovery method is the only method available for “real” property placed in service at this time. According to that method, commercial properties are given a 39-year tax life by the IRS and residential properties — apartment buildings included — are given a 27.5-year tax life, meaning you can divide the tax basis by either 39 or 27.5, and deduct the result from your ordinary income each year until the property is fully depreciated. For example: $750,000 divided by 39 years equals $19,230 per year that can be deducted from ordinary income.

The Tax Relief Act of 1997 made changes to the taxation of improved commercial and investment real estate. For properties sold after May 6, 1997, a non-corporate taxpayer will be required to “recapture,” or pay taxes on any straight-line cost recovery (depreciation) taken during the holding period of the asset.

That is accomplished by the property owner paying back a maximum of 25 percent of the depreciation (tax relief) to be taken at the time of disposition of the depreciated asset. Recapture taxes are paid in addition to and before capital gains taxes. Like capital gains taxes, recapture taxes can be deferred in a 1031 exchange. Due to the unique nature of each taxpayer’s situation, a detailed discussion of this subject with a tax professional is extremely important.

There is also cost segregation (see smdp.com, Feb. 11, 2006, page 11) for a more in-depth explanation). That form of depreciation allows a property owner to divide a building into components. Depreciating portions of the building separately, many of the components are most likely eligible for a shorter tax life and considered personal property, allowing for larger amounts of depreciation sooner (accelerated depreciation) and effectively increasing an investor’s after-tax cash flow even more.

Examples of those components are the roof, the HVAC system, window coverings, etc. Cost recovery must be reviewed with the investor’s tax professional to ensure accuracy and to fully understand the potential tax benefits.

(You can reach Christina Porter at 1-877-4 TM 1031, or e-mail her at christina@tm1031exchange.com to discuss your specific needs. TM 1031 Exchange assists investors in planning and executing successful real estate investment strategies. Visit www.tm1031exchange.com for a complete list of investment properties and to download the TM 1031 Tool Kit. TM 1031 Exchange successfully did more than $100 million in 1031 exchanges in 2005.)