Real estate is a fixed asset; it's real and tangible.
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Like many other assets, over time it wears out. For accounting purposes, you are able to take credit for a huge expense each year – called depreciation expense – to give yourself credit for the way your asset is wearing out. Here's how it works:
Land does not depreciate
When you hold real estate you need to be able to separate out the land from the improvements on the land. Unfortunately for the owner of property, land is not a depreciable asset. So the first thing you need to do if you own commercial real estate is separate out the cost of the land from the cost of the improvements (buildings) on the land.
Establish a baseline value and time horizon
The time horizon for real estate depreciation is established by convention. Typically, a residential property will be depreciated over 27.5 years. For commercial properties a 39 year depreciation schedule can be used. The idea is that you want to establish the time horizon by which the property will have worn out.
The baseline value to begin your depreciation should be the amount you spent on the property, less the land value. This can be tricky. If you bought land and then constructed improvements yourself, this is easy. If you bought a finished property you may want to get the advice of a professional to help you separate out the land value from the improvements.
Make the accounting entries
Let's look at a simple example of how you would make the accounting entries for a commercial property. Imagine that you paid $1 million for a piece of land, and then $20 million for the improvements on it. As a commercial property you want to depreciate it in a straight line over 39 years. That means that each year you can take 1/39th of the value of the improvements and take it as an expense.
Thus, you would debit depreciation expense in the amount of $512,820.51 and credit your real estate asset $512,820.51. You would make this entry once a year every year until you either sell the building or until the 39 years is up. The depreciation expense is a liability account, and so you must debit it. The real estate asset is obviously an asset account, so you credit it. This will draw down the size of your real estate assets on your balance sheet over time.
Keep in mind that in addition to the initial amount, you will also be able to depreciate capital expenditures that you make over the life of the property. If you replace the roof on your building for $1 million dollars, you should go ahead and start depreciating that as well. Consult a tax professional and/or accountant, however, to make sure you have an appropriate schedule.
The best part about the depreciation expense is that it is a non-cash expense. This means that if you have $750,000 in cash flow and $512,820.51 in depreciation expense you will only appear to have $237,179.49 in income for tax purposes (before deducting other expenses). This makes owning commercial real estate a very attractive proposition.