Depreciation expense calculation is difficult and complicated. Yes, I totally agree. Perhaps you just bought your first property and wonder how to calculate the depreciation expense for your real estate property or you have had real estate properties for a while already but wonder if you could calculate the depreciation expense, either way, this blog is to give you the basic ideas how to tackle the calculation of depreciation expense calculation and where you can get the authoritative guidance. Sure, you can simply ask your accountant but it is always better to study a little bit before the meeting to have a more fruitful meeting.
explain about MACRS…
Here is the list of things you should know how to calculate the depreciation expense
- Basic understanding of depreciation
- Adjusted basis of your asset (Asset value)
- Criteria to calculate (Estimated life time of asset)
- Let’s calculate
Basic understanding of depreciation
Depreciation : a reduction in the value of an asset with the passage of time, due in particular to wear and tear.
The super basic calculation of depreciation expense
Asset value / Estimated life time of asset = Depreciation expense
Yea sure… so what? Right? Let me explain depreciation in more general language. Any asset is expected to depreciate over the time of asset. Nothing exists forever. A car is a good example. You buy a brand new car but in a few years, the car will lose almost a half of the value. Why? Because it has depreciated over the time. Things “depreciate” and eventually they will not be usable anymore. That is why, accounting system was created to record the depreciation expense every year to be able to record as an “expense” as you used a part of your asset off as much as the expense. Expense is a good thing because it reduces your taxable income. Here is the super basic calculation of depreciation expense and I will go over one by one.
Adjusted basis of your asset (Asset value)
I mentioned “Asset value” but it is not the simple amount you purchased. What are the items you actually pay for other than the property itself? Title insurance, broker fee, and Lawyer fee and etc… these items could be actually capitalized. Capitalize means you can record it as a part of your asset. Which is called Adjusted basis. What items should you actually consider for the calculation?
Items to include
Here are some items that you may actually have to include for your depreciation expense calculation.
1. Real estate taxes.
If you pay real estate taxes the seller owed on real property you bought, and the seller didn’t reimburse you, treat those taxes as part of your basis. You can’t deduct them as taxes.
If you reimburse the seller for taxes the seller paid for you, you can usually deduct that amount as an expense in the year of purchase. don’t include that amount in the basis of the property. If you didn’t reimburse the seller, you must reduce your basis by the amount of those taxes.
2. Settlement costs.
Your basis includes the settlement fees and closing costs for buying property. You can’t include in your basis the fees and costs for getting a loan on property. A fee for buying property is a cost that must be paid even if you bought the property for cash.
The following items are some of the settlement fees or closing costs you can include in the basis of your property.
- Abstract fees (abstract of title fees).
- Charges for installing utility services.
- Legal fees (including title search and preparation of the sales contract and deed).
- Recording fees.
- Transfer taxes.
- Owner’s title insurance.
- Any amounts the seller owes that you agree to pay, such as back taxes or interest, recording or mortgage fees, charges for improvements or repairs, and sales commissions.
Items to exclude
Here are the examples to exclude from your calculation.
- Casualty insurance premiums.
- Rent for occupancy of the property before closing.
- Charges for utilities or other services related to occupancy of the property before closing.
- Charges connected with getting a loan. The following are examples of these charges.
- Points (discount points, loan origination fees).
- Mortgage insurance premiums.
- Loan assumption fees.
- Cost of a credit report.
- Fees for an appraisal required by a lender.
- Fees for refinancing a mortgage.
You must be like what??? But yes, Land is not depreciable. Remember. Things depreciate because they will not be usable anymore. Land will be usable pretty much forever as long as the earth exists. That is why IRS says we cannot include the amount of Land in our base to calculate the depreciation asset. You should take the amount if stated in the deed or any official documents you signed. A lot of cases, it does not state the specific amount. What should you do? if you have an accountant, you should definitely ask your accountant. But if you like to calculate it by yourself, it seems like 80 (Property) :20 (Land) is the most common split rate that a lot of accountants use. If you paid $1,000,000, you should allocate $200,000 to your land.
Please refer here for more details, Publication 551 .
Here is the example for adjusted basis.
- The amount of property ; $1,000,000
- Title related fee ; $6,000
- Legal fees ; 4,000
- Land ; -$200,000
Your property’s adjusted basis is $810,000.
Criteria to calculate (Estimated life time of asset)
Now what do you multiply the adjusted basis by? For real estate property, there are basically two ways to calculate the depreciation expense. 1) You consider the asset as one asset. The adjusted basis calculation I just showed above. 2) There is another way to do it and it could be very tax effective if you do it right. However, it requires lots of experiences and knowledges. Basically, breakdown the asset into smaller separable assets such as roof if it was improved, large equipment came with the property, or super valuable appliances. You can calculate the depreciation expenses for the smaller each asset separately because each asset has a different estimated life time of asset. A car will depreciate in 10 years, an equipment in 5 years, an appliance in 3 years. The total asset amount of separated assets have to agree with the amount you paid. But for this time, I will just show the 1) simple depreciation calculation.
Table to find the depreciation rate you should use
The simple way to calculate your real estate properties, there are only 4 ways. Here is the actual table from IRS.
What questions should you ask?
- Residential or Non residential?
- GDS or ADS?
The first question is simple. It is just yes or no. The second question. GDS stands for General Depreciation System and ADS stands for Alternative Depreciation System. GDS says “General” so most of you select this method to calculate. In order to select ADS or you have to select ADS, your property has to meet some criteria.
Required use of ADS.
You must use ADS for the following property.
- Nonresidential real property, residential real property, and qualified improvement property held by an electing real property trade or business (as defined in section 163(j)(7)(B) of the Internal Revenue Code). For more information, see Revenue Procedure 2019-8 on page 347 of the Internal Revenue Bulletin 2019-3 available at www.irs.gov/irb/2019-03_IRB#RP-2019-08.
- Any property with a recovery period of 10 years or more under the GDS held by an electing farming business (as defined in section 163(j)(7)(C) of the Internal Revenue Code). For more information, see Revenue Procedure 2019-8 on page 347 of the Internal Revenue Bulletin 2019-3 available at www.irs.gov/irb/2019-03_IRB#RP-2019-08.
- Any tax-exempt use property.
- Any tax-exempt bond-financed property.
- All property used predominantly in a farming business and placed in service in any tax year during which an election not to apply the uniform capitalization rules to certain farming costs is in effect.
- Any property imported from a foreign country for which an Executive Order is in effect because the country maintains trade restrictions or engages in other discriminatory acts.
- Certain property of an electing real property trade or business (as defined in section 163(j)(7)(B) of the Internal Revenue Code).
- Certain property of an electing farm business (as defined in section 163(j)(7)(C) of the Internal Revenue Code).
Here is the authoritative guidance if you like to dive deeper. Publication 946
So. If you are a common condo or single family owner, you select Residential and GDS. Your estimated life term of your property will be depreciated over the next 27.5 years. Here is the actual rate table you should use.
Let’s calculate the first year of your depreciation. Assume you bought your property in January. The adjusted basis calculated earlier $810,000.
|Year||Rate from A-6||Depreciation amount for the year|
Notice, at the end, the total amount that you have depreciated over the period should be the total of amount you purchased.
For your bookkeeping purpose. Here are the journal entries you should record.
You have 810,000 on your balance sheet as a fixed asset (Assuming you bought it with Cash).
Dr. Fixed Asset $810,000
Cr. Cash $810,000
You realize the depreciation expense every year and the amount goes to income statement. To properly reflect the depreciation on the balance sheet, you record the counter side as accumulated depreciation. This way, the net amount of fixed asset reflects the appropriate amount. The journal entry of the first year should be :
Dr. Depreciation expense $28,228.50
Cr. Accumulated depreciation $28,228.50
If you like to bookkeep it every month, simply divide it by 12 and record it.
Now you know how to calculate the depreciation expense for your property right? Yea yea… maybe not… but if you read it again and check the table, you should be able to calculate it by yourself. The questions you should ask is simple. 1) Is it a residential or commercial? 2) Would you like to select GDS or ADS? 3) Check the table from IRS to find the right rate.