How do you depreciate commercial property improvements?

1 What are commercial property improvements?

Commercial property improvements are any additions or alterations you make to your property that enhance its value, functionality, or appearance. For example, you may install new flooring, lighting, or HVAC systems, or renovate your lobby, bathrooms, or offices. Commercial property improvements are different from repairs or maintenance, which are expenses that keep your property in good working condition, but do not increase its value or usefulness. Repairs and maintenance are usually deductible in the year they are incurred, while improvements are depreciated over time.

2 How do you determine the depreciation method and period?

The depreciation method and period you use for your commercial property improvements depend on several factors, such as the type of property, the nature of the improvement, and the date of the improvement. Generally, you can use one of two methods: the general depreciation system (GDS) or the alternative depreciation system (ADS). The GDS is the default method, and it allows you to depreciate your improvements faster than the ADS. However, the ADS may be required or preferred in some situations, such as when you use your property for tax-exempt purposes, or when you elect to use the ADS for all your property.

The depreciation period is the number of years over which you can deduct the cost of your improvements. The GDS and the ADS have different depreciation periods for different types of property and improvements. For example, under the GDS, you can depreciate most nonresidential real property over 39 years, while under the ADS, you have to use 40 years. However, some improvements may qualify for shorter depreciation periods, such as 15 years for qualified leasehold improvements, qualified restaurant property, or qualified retail improvement property.

3 How do you calculate the depreciation amount?

The depreciation amount is the portion of the cost of your improvements that you can deduct each year. To calculate the depreciation amount, you need to know three things: the basis, the recovery period, and the depreciation method. The basis is the amount you paid for the improvement, plus any related costs, such as installation fees, permits, or taxes. The recovery period is the same as the depreciation period, which is determined by the type of property and improvement, and the system you use (GDS or ADS). The depreciation method is the formula you use to allocate the basis over the recovery period. The most common depreciation methods are the straight-line method and the modified accelerated cost recovery system (MACRS).

The straight-line method is the simplest method, and it allows you to deduct an equal amount of the basis each year over the recovery period. For example, if you spend $100,000 on a 39-year improvement, you can deduct $2,564 ($100,000 / 39) each year. The MACRS is a more complex method, and it allows you to deduct a larger amount of the basis in the earlier years, and a smaller amount in the later years. The MACRS has different tables and rates for different types of property and improvements, and you have to follow the rules and conventions for each category.

4 How do you report the depreciation on your tax return?

The depreciation on your commercial property improvements is reported on your tax return as part of your rental income and expenses. You have to use Form 4562, Depreciation and Amortization, to list your property and improvements, and to calculate and claim your depreciation amount. You have to attach Form 4562 to your Schedule E, Supplemental Income and Loss, where you report your rental income and expenses from your commercial real estate. You have to file Form 4562 and Schedule E with your Form 1040, U.S. Individual Income Tax Return, or Form 1120, U.S. Corporation Income Tax Return, depending on your business structure.

5 What are some common mistakes to avoid?

Depreciating commercial property improvements can be a complicated and confusing process, and you may make mistakes that can cost you money or trigger an audit. To avoid this, it is important to differentiate between improvements that increase the value or usefulness of your property, and repairs or maintenance that keep your property in good condition. Additionally, you must select the appropriate depreciation method and period for your type of property and improvement, and the system you choose (GDS or ADS). Lastly, it is essential to keep track of your improvement costs, dates, and details, as well as all the receipts and invoices that support your depreciation claim. Without proper records and receipts, you may not be able to substantiate your depreciation amount, thus risking an audit or a disallowance.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?