At first glance, depreciation might seem like a downside to commercial real estate investment. After all, depreciation refers to the decline in an asset’s value over time—exactly the opposite of what most investors expect from an investment. But it turns out that depreciation is actually a powerful tool that CRE investors can use to lower their overall tax burden and improve their total returns.
The benefits of depreciation come from rules put forward by the Internal Revenue Service (IRS) in the federal tax code. The IRS allows investors to deduct the value of their investment in a commercial property from their annual income tax liability over a period of 39 years. For example: if the value of a multifamily apartment building and improvements is $1,000,000, an investor can use depreciation to deduct up to $25,641 ($1,000,000 divided by 39) each year from his or her taxable income.
Investors can reap the benefits of depreciation annually until one of two things takes place:
1. The entire basis of the property has been deducted.
The basis is simply the cost of the property minus the value of the land. It’s important to note that depreciation only applies to the property and improvements, not the underlying land value.
2. The property is sold or is no longer generating income.
The example above deals with a simple case of “straight line” depreciation, where deductions are claimed annually over the full period allowed by the IRS. However, many commercial real estate investors use a different method of calculating depreciation, called cost segregation.
Simply put, different components of a commercial real estate asset have different lifespans. For example, office furniture can be expected to have a shorter lifespan than a parking lot. Cost segregation accounts for the different lifespans of these components and depreciates them at different rates. In practice, this front loads depreciation deductions and thus increases cash flow in the early years of property ownership.
For savvy real estate investors, expected depreciation can be just as important as anticipated cash flows or price appreciation when evaluating the return profile of a deal. Our team at LEX recognizes this, which is why we’ve built a unique offering structure that allows our investors to reap the full benefits of depreciation. Our securities are structured as K-1 investments, meaning that as an LEX investor, you hold a partnership interest in any asset you purchase. You sit side-by-side with the property’s majority owner, and consequently you’re able to reap the full benefits of depreciation at tax time.
LEX Markets does not provide tax, legal or accounting advice. Potential investors are encouraged to consult with professional tax, legal, and financial advisors before making any investment into a securities offering. This investment may not be suitable for all investors. Distributions and liquidity not guaranteed. Property performance and performance of property tenants not guaranteed. Diversification does not eliminate the risk of experiencing investment loss.
November 15, 2022
The debt service coverage ratio (DSCR) measures an ability of a property to meet its debt obligations. It’s expressed as the ratio between an asset’s net operating income (NOI) and its debt service costs.