Cost Recovery

The deduction for cost recovery (depreciation) relies on the premise that real estate is a wasting asset, which means the asset loses value with age and use. Therefore, under federal tax law, the owner may take a deduction from taxable income for the tangible property used up (through exhaustion, wear and tear, and normal obsolescence) in a trade or business or for the production of income. Cost recovery reduces net taxable income from the property.

Cost recovery is a temporary deferment of taxes that is allowed by the IRS to recover the cost of a depreciable asset. It is temporary because the amount that is deducted must eventually be dealt with when the property is sold.

Cost recovery is the primary source of tax shelter in real estate. Cost recovery deductions do not represent cash payments and therefore have no impact on cash
flow. They are a “paper” expense only that is recognized on the taxpayer’s income tax form.

Cost Recovery Deductions
The Internal Revenue Code of 1954 (the Code) is the basic set of rules about taxation. Administered by the Internal Revenue Service, the Code has been revised
many times since 1954. The real estate manager must understand how the evolving Code has affected owners of rental properties.

Cost recovery deductions are most often calculated using percentage tables provided in IRS Publication 946, How to Depreciate Property, which is revised to reflect
requirements for each tax year. All real property uses one of three tables:

• Table A-6: Residential Rental Property: includes real property from which 80% or more of gross rental income is attributable to dwelling units. It does not include hotels, motels, inns, or other establishments where more than half the units are used on a transient basis. The cost of residential real property can be depreciated over 27.5 years using IRS Publication 946, Table A-6.
• Table A-7: Nonresidential Real Property: includes real property that does not qualify as residential real property. The cost of nonresidential real property placed in service by the current owner before May 13, 1993, can be recovered over 31.5 years using IRS Publication 946, Table A-7. 
• Table A-7a: Nonresidential Real Property: covers the cost of nonresidential real property placed in service by the current owner after May 12, 1993, which can be recovered over 39 years using IRS Publication 946, Table A-7a.

The cost of residential and commercial real estate placed in service in recent years is recovered using the straight-line method. In the straight-line method, deductions are the same for each year of the cost recovery period. The straight-line method must be used on rental real estate placed in service after 1986, and it may be chosen for other types of property.

Cost Recovery Periods
As discussed in the previous section, IRS rules dictate the following cost recovery periods:

• Residential properties = 27.5 years or 1/27.5
• Other income properties = 31.5 years or 1/31.5; 39 years or 1/39
• Optional = 40 years or 1/40

The mid-month convention is used for real property. This means that only half of a month’s depreciation is allowed in the months of acquisition and disposition, regardless of when during the month the property acquisition or disposition occurred. Visit the IRS Web site for more information and to download IRS
Publication 946, How to Depreciate Property.