In real estate valuation, depreciation refers to the systematic reduction in a property's value over time due to aging and obsolescence of improvements (buildings, fixtures) while the land often retains or appreciates in value. This is distinct from market value, which reflects the price a buyer would pay under current market conditions, irrespective of the underlying physical or functional decline of the structure.
Depreciation is a cornerstone in appraisal and underwriting models. Investors use it to project cash flow and tax benefits, brokers factor it into pricing strategies, and appraisers adjust comparable sales to reflect differences in age, condition and functionality of properties.
Physical deterioration covers loss of value from aging materials and systems: peeling paint, roof leaks, HVAC failures and worn flooring. It can be curable (e.g., repainting) or incurable (e.g., structural settlement).
Functional obsolescence arises when a property's design or features fall out of market favor. Examples include outdated kitchen layouts, low ceiling heights or lack of modern wiring and plumbing.
External obsolescence is value loss due to factors outside the property boundaries, such as increased traffic, zoning changes, environmental hazards or neighborhood decline. It is almost always incurable by the owner.
Straight-line depreciation spreads the depreciable basis evenly over the asset’s useful life. Formula: (Cost of improvements – Salvage value) ÷ Useful life. Pros: simplicity and predictability. Cons: ignores accelerated loss in early years.
Accelerated methods front-load depreciation deductions. Double-declining multiplies book value by 2 ÷ useful life each year, while sum-of-years’ digits allocates a decreasing fraction of basis annually. These methods match higher expenses to earlier years of higher maintenance and technology turnover.
Straight-line is preferred for long-lived assets with consistent wear; accelerated methods suit short-lived or high-tech components, or when tax planning demands higher early deductions.
Since land is not depreciable, allocate the purchase price based on local market ratios. Example: $1,000,000 purchase price with 20% land value = $200,000 land, $800,000 building basis.
Useful life is the IRS or appraisal assumption of economic life (27.5 years for residential, 39 years for commercial). Effective age = (Actual age ÷ Economic life) × 100%.
Residential example: $800,000 basis ÷ 27.5 years = $29,090.91 annual depreciation. Commercial example: $2,000,000 basis ÷ 39 years = $51,282.05 annual depreciation.
Accumulated depreciation reduces the adjusted tax basis, increasing taxable gain on sale. Adjusted basis = Original cost – Accumulated depreciation + Capital improvements.
Depreciation is a non-cash expense, reducing taxable income and thus boosting after‐tax cash flow without affecting NOI directly.
Appraisers may add back accumulated depreciation to market value estimates, adjusting cap rates to reflect true earning potential of newer vs. older properties.
The IRS prescribes the Modified Accelerated Cost Recovery System (MACRS): residential rental property over 27.5 years, commercial over 39 years.
Appraisal depreciation reflects actual wear and market obsolescence; IRS schedules follow a statutory timeline, regardless of condition. Analysts often reconcile both to align financial and tax models.
Overstating basis or using incorrect useful lives can trigger IRS audits. Maintain detailed records of purchase price allocation, improvements and depreciation schedules.
Use standardized spreadsheets or software that separate land and building values, track accumulated depreciation and update useful-life assumptions.
Highlight depreciation expense, projected tax savings and terminal cap‐rate adjustments in investment summaries.
Investor purchases at $1.2 million.
Allocate 25% to land: $300,000 land, $900,000 building.
Select 27.5-year straight-line for residential rental: ($900,000 ÷ 27.5).
Annual expense = $32,727.27. Depreciation reduces taxable income, increases after-tax cash flow but does not alter NOI.
Investor leverages $32,727 annual non-cash deduction to lower tax liability, enhancing net yield and return on equity.
It’s (Cost of improvements – Salvage value) ÷ Useful life.
Use local market allocation percentages or tax assessor ratios to assign value between land and improvements.
Typically 7–15 years for roofs, 10–20 years for HVAC and 15–25 years for elevators, depending on quality and maintenance.
Appraisers often add back accumulated depreciation when using the income approach to normalize NOI and derive market‐value cap rates.
Yes. Since depreciation is a non-cash expense, it lowers taxable income, reduces tax liability and increases after‐tax cash flow.
