As an initial caveat, we are not tax professionals, and this information is for general information only. Please contact your tax professional for advice specific to your situation.
Depreciation of healthcare real estate, like other commercial real estate asset classes, is a tax benefit that may be just as important to an investor’s overall analysis of the property as its projected income or future appreciation. That’s because the Internal Revenue Service (IRS) allows an investor to offset his or her taxable income by making an annual deduction for depreciation of the property.
What is depreciation?
The IRS defines depreciation as “an annual income tax deduction that allows you to recover the cost or other basis of certain property over the time you use the property. It is an allowance for the wear and tear, deterioration, or obsolescence of the property.” IRS Publication 946 (2021).
Although land (which does not wear out, become obsolete or get used up) cannot be depreciated, tangible property such as buildings, machinery and equipment can be depreciated if:
(1) the investor owns the property;
(2) he or she uses it in his or her business or income-producing activity;
(3) the property has a determinable useful life—it is something that wears out, decays, becomes obsolete or loses value from other natural causes; and
(4) the useful life is expected to be more than one year.
An investor who owns property subject to a mortgage is still considered an “owner” of the property for purposes of claiming a depreciation deduction.
When does a property begin to depreciate?
A property begins to depreciate when it is placed in service for use in a business activity or the production of income, which could be from the moment the property is acquired or on a date after the acquisition.
As an example, consider an investor who buys a vacant medical building on February 1st but makes renovations and improvements to the building that are not complete until March 1st, on which date the investor begins marketing the property for rent to prospective tenants. The IRS would consider the property “placed in service” and depreciable starting March 1st when it was ready and available for rent. If, on the other hand, the investor bought on February 1st a fully leased, turn-key medical building that needed no renovations to make it ready for rent, then the IRS would likely consider the property placed in service as of that date.
How is a deduction for depreciation calculated?
The IRS allows depreciation of a commercial property over a period of 39 years (27.5 years for residential properties). An investor may take an annual depreciation deduction in each of those 39 years.
In order to calculate a property’s depreciation, the property’s basis must first be determined. In most cases, a property’s basis is its cost (excluding the value of the land). The basis of real property is cost plus amounts paid for sales tax and items on the settlement statement such as recording fees, survey charges and title insurance. Property tax assessors’ values can be used to determine the value of the land.
Let’s say, for example, an investor purchases a warehouse for $1,000,000 of which $750,000 was for the building and $250,000 was for the land. The calculation for annual depreciation expenses would look like this:
Basis = $1,000,000-$250,000 = $750,000 (Cost of property – Value of land)
Annual Depreciation Expense = $19,230 ($750,000/39 years)
The investor can deduct $19,230 from his taxable income each year for 39 years.
What happens when a depreciated asset is sold?
When a depreciated asset is sold, the investor may owe taxes through what is known as depreciation recapture. The investor must report the difference between the basis and the sales price as ordinary income (up to a max of 25%). In other words, the IRS can collect taxes on the gain an investor makes upon the sale of an asset he or she previously used to offset income by taking depreciation deductions. To avoid these taxes, an investor can complete a 1031 exchange in which he or she purchases a like-kind property. In that situation the investor does not realize a gain in the eyes of the IRS and therefore can defer the tax liability.