Depreciation (Real Estate)
Depreciation in real estate has two meanings: for tax purposes, it is the annual deduction for the cost of investment property over time (27.5 years residential, 39 years commercial); for appraisal, it is the loss in value due to physical, functional, or external obsolescence.
Exam Tip
Physical = wear/tear. Functional = outdated. External = outside factors (ALWAYS incurable). Tax: Residential 27.5 yrs, Commercial 39 yrs. Land is NOT depreciable!
What is Depreciation in Real Estate?
Depreciation has different meanings in real estate depending on context: tax depreciation is a deduction that benefits investors, while appraisal depreciation measures actual loss of value.
Tax Depreciation
Tax depreciation allows property owners to deduct the cost of investment property over its useful life, even if the property is actually appreciating in market value.
| Property Type | Recovery Period |
|---|---|
| Residential Rental | 27.5 years |
| Commercial Property | 39 years |
| Land | NOT depreciable |
Calculating Tax Depreciation
Annual Depreciation = (Building Value) / Recovery Period
Example:
- Property Purchase: $300,000
- Land Value: $50,000
- Building Value: $250,000
- Annual Depreciation (Residential): $250,000 / 27.5 = $9,091
Types of Appraisal Depreciation
The cost approach to appraisal considers three types of depreciation:
| Type | Description | Examples | Curable? |
|---|---|---|---|
| Physical Deterioration | Wear and tear from age and use | Worn roof, old HVAC, peeling paint | Often curable |
| Functional Obsolescence | Outdated design or features | Small rooms, only 1 bathroom, no garage | May be curable |
| External (Economic) Obsolescence | Factors outside the property | Highway noise, declining neighborhood, factory nearby | NOT curable |
Physical Deterioration
| Type | Description |
|---|---|
| Curable | Cost to repair is less than value added (deferred maintenance) |
| Incurable | Cost to repair exceeds value added (structural issues) |
Functional Obsolescence
| Type | Description | Example |
|---|---|---|
| Curable | Economical to fix | Adding a bathroom |
| Incurable | Too expensive to fix | Can't add second floor |
| Deficiency | Missing features | No central air |
| Superadequacy | Over-improvement | Pool in cold climate |
External (Economic) Obsolescence
| Factor | Example |
|---|---|
| Location Changes | New highway next door |
| Economic Decline | Factory closures, job losses |
| Zoning Changes | Unfavorable rezoning |
| Environmental | Contamination nearby |
| Market Conditions | Oversupply in area |
Tax Depreciation vs. Appraisal Depreciation
| Tax Depreciation | Appraisal Depreciation |
|---|---|
| Paper deduction for tax benefits | Actual loss in property value |
| Calculated by IRS rules | Determined by appraiser analysis |
| Property may actually appreciate | Reflects real market conditions |
| Buildings only (not land) | Applies to improvements |
Depreciation Recapture
When investment property is sold, depreciation taken is "recaptured" and taxed at up to 25%.
Exam Alert
- Physical deterioration = wear and tear (often curable)
- Functional obsolescence = outdated design (may be curable)
- External obsolescence = outside factors (NEVER curable)
- Tax depreciation: Residential = 27.5 years, Commercial = 39 years
- Land is NEVER depreciable
- External obsolescence is the only type that is ALWAYS incurable
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Related Terms
Appreciation
Real EstateAppreciation is the increase in a property's value over time due to market conditions, improvements, inflation, or increased demand, representing a key source of real estate investment returns.
Appraisal
Real EstateAn appraisal is a professional assessment of a property's market value, typically required by lenders before approving a mortgage to ensure the loan amount is appropriate.