The Vital Concept of Depreciation in Real Estate

By Dan Harkey

When a building or improvement is completed, its value and “usability” decline. Physical deterioration, functional obsolescence, and economic obsolescence reduce the value of improvement over time. Depreciation is the loss in property value from any cause. Understanding depreciation is not just a matter of knowledge; it's a key to unlocking significant financial benefits. ?Whether buying a property, securing a loan, or planning improvements, your financial decisions will be influenced by the physical aspects of depreciation and the potential income tax benefits. This understanding can empower you to make more informed and profitable transactions. Here are some practical basics to work with:

• Physical Deterioration:

·????? Curable- These can be corrected reasonably, such as deferred maintenance, wear and tear, cracks, paint, roofing, dry rot, and infestation.

·????? Incurable- Things that cannot be practically or economically corrected, such as settling a building or structure or when the property is old and so worn out that repairing it is not financially practical.

• Functional Obsolescence:

·????? Curable- Design defects and outdated buildings.

·????? Incurable—Deficiencies that are not practically fixed, such as retail and office buildings lacking offsite parking, apartments without garages, or less-than-adequate parking.

• Economic Obsolescence:

·????? Issue caused by negative influence outside the site.? Examples include zoning changes, business districts moving away, freeway offramps close by, and employment bases changing or eliminating. A legal nonconforming use is a use of lands or structures legally established according to the applicable zoning and municipal building laws at the time but which does not meet current zoning and building regulations. A use or structure can become legally nonconforming due to rezoning, annexation, or revisions to the Zoning Code. On my website, danharkey.com, I go further in-depth on “Conforming vs. Nonconforming.” please follow the link to read that?article?

• Book depreciation:

·????? Understanding book depreciation can be a powerful tool for real estate investors. This accounting terminology refers to the owner’s tax efforts to recapture the investment by writing off the physical structures. Also, depreciating the associated business personal property is used. Owners attempt to reduce taxable income through what is referred to as “tax incentive Investments.” This knowledge can open new avenues for reducing taxable income and increasing financial gain.

·????? Here are a few examples I have encountered while dealing with depreciation. These practical examples are designed to make depreciation more tangible and easier to understand, reassuring you that you can grasp this complex topic and apply it to your real estate ventures. Physical curable: When assessing the upgrading of a property, the cost usually makes economic sense to fix up rather than replace the structure.? An entire industry based upon this concept is the fix-and-flip industry. Fix-ups are common because all properties physically deteriorate over time and need a facelift.?Millions of homes were built post WWII between 1000 and 1500 square feet, and row homes in symmetrical neighborhoods were designed for middle-class family expansion during the 1950s and 60s. The houses generally had a small kitchen, dining room, and small living room intended for separateness. Lots were typically large enough for add-on rooms and patios.? The cluster feeling of small rooms has now been changed to “open concept floor plans” with fewer walls and sitting-level kitchen countertops, giving the sense of a bigger home where all the family can gather together in a larger space. The owner can revitalize the economic viability and make the home more livable by reconfiguring the floor plan and adding modern appliances and equipment. ?The renovation was cost-effective and updated to a contemporary feeling.

An income property built around 1970 had a kitchen separated with Formica countertops and ceiling-hung cabinets designed to hold dishes and glasses.? It made the room feel small and clustered.? The sink was placed against a blank wall.? The whole kitchen felt like a dark and dank lousy dream.? Replacing the countertops, removing the ceiling cabinets, and relocating the sink under a window opened the room! The kitchen and living area were combined by installing a small island with storage cabinets below. The kitchen went from dark and dank to bright and new! Physical incurable # 2: This is a much more complex subject because the defects are known, but there is no practical or cost-effective method of fixing the problem. Examples include residential rentals and commercial units built with little or no on-site parking, low ceiling heights for industrial buildings, and a lack of dock heights in industrial buildings.·????

I once made a loan to the Dana Villa Motel in Dana Point, California. The property was built in 1928 when Dana Point was first subdivided into a beach community. It was located on Pacific Coast Hwy, close to the shoreline of Doheny State Beach. Remember the Safaris??? “Down in Doheny, where the surfers all go, there’s a big bleach blondie named Surfer Joe.”

What do you do with a picturesque Spanish stucco and tile roof with a backdrop of the Pacific Ocean? ?I immediately sold to a new opportunistic developer who had his vision about the future of this property. After multiple construction bids, a test for dry rot, a water table study, and interaction with the city planning department, it is evident that it would cost as much to fix it up as demolishing and building a new building. It took a while because the community’s “Surfer Joes” wanted it rehabilitated so that they could drive by and romanticize about their youth and days have gone by. The owner took the heat, obtained a permit, and demolished the pile of junk. Problem solved! A duplex was initially constructed in the 1970s. The decision had to be made whether to rehab or demolish and reconstruct a new building.? In the 1970s, the city zoning ordinance allowed four units per 4000 sq. ft. lot. Later, a down-zoning only allowed two units per 4000 sq. ft.? Later, another down-zoning?occurred, allowing 1 unit per 4000 sq ft.? The city kept a provision for rehabilitating property by taking it down to the frame and then starting on the reconstruction.? The decision was to build a new modern duplex with a much better floor plan and panoramic ocean views. One lowly wall was left to satisfy the city's requirement. That wall disappeared and was replaced when the insulation and drywall were installed.? The result was an economically more feasible modern building with much higher rent. Economic Obsolesce: “Get your kicks – on Route 66.” I came to California from Arkansas in 1954 in a 1950 Chevy pick-up truck, six-cylinder, three-speed on the floor with no air-conditioning, which made crossing the Arizona/California desert at 110-degree heat a not-so-enjoyable drive. Route 66 is reflected in history books and revisited by people like me for cultural remembrance. Chuck Berry and Nat King Cole, among others, sang “Get Your Kicks on Route 66.”? All the business, commercial, retail, and many residential buildings were displaced by the new “grand highway,” leaving Route 66 behind in the dust.??If you were politically powerful, you could re-direct growth toward your property. If you couldn’t, you were out of luck.? Commercial retail properties?that lack driveways and have only one source of ingress/egress are also problematic. Residential properties built in a neighborhood a decade ago sadly back up to a freeway or busy street, causing them to be valued less than properties that did not suffer the same fate.? Book depreciation: Current depreciation?schedules are referred to as “straight lines,” and the cost of improvements is generally deducted over 28 years.? With investment property, you will declare a loss in the improvements' value over time. First, you separate the land value from the upgrades/structures, as they can be depreciated for federal and state tax purposes. The tax advantage is now marginal at best but enables owners to shelter some of their rental income from taxes.

Recapture of depreciation can return and bite you in the__. ?That means that when you dispose of the real property asset, all the depreciation is recaptured as ordinary income and taxed at your highest marginal rate. Please discuss this with your CPA.

Dan Harkey

Educator and Private Money Finance Consultant

949 533 8315 [email protected]

Visit www.danharkey.com