Establishing Basis for Depreciation

By Alec Pacella, CCIM
Managing Partner at NAI Daus
apacella@naidaus.com
(216) 455-0925
Twitter @dausyouknow

Several years ago, we focused on the concept of cost recovery (also known as depreciation) in a couple of columns. This month, we are going to dig a little deeper into this concept, but before you tune out and flip to a different part of the magazine, ask yourself two questions. First: do you/your company/your clients pay taxes? And second: do you/your company/your clients care more about how much you make or how much you keep? If the answer to these questions is “yes,” I would recommend that you read on.

Cost recovery is an acknowledgment by the IRS that real estate is subject to wear and tear over time. To offset this, they allow an owner to recognize cost recovery. The general concept is that the owner’s original basis in the real estate is reduced each year as a result of the deprecation of the improvement portion of the real estate. This can be a clear benefit to the owner, as the cost recovery taken each year is deducted from any income each year. The result is a shelter for the owner, as they will be subject to tax on income after recognizing cost recovery, not before. I have simplified this concept and there are numerous nuances associated with the process. This month, we will focus on a specific nuance that occurs at the very beginning of the process – establishing original basis.

Basis is both an accounting and a tax concept. It is the benchmark value that is subsequently used to determine the amount of cost-recovery deduction, amortization deduction and gain or loss when the property is sold. Basis is established at the time of acquisition and must be allocated between the portions of the property that are attributable to land, improvements and, if applicable, personal property. Allocating the original basis is important because land is not subject to cost recovery. But, similar to many things in my life, we’ll put that in a box on the shelf and deal with it another day. The focus this month is on the nuances associated with establishing the original basis. Click here to continue reading article.