In connection with the appraisal of real property, depreciation is defined as "loss in value from any cause." It is customarily measured by estimating the difference between the current replacement or reproduction cost new and the estimated value of the property as of the date the property was appraised.
Contrasting with depreciation is appreciation of value from inflation or special supply and demand forces relating to the specific property. Appreciation may reduce or offset entirely a normally anticipated decrease of value due to depreciation.
Depreciation includes all of the influences that reduce the value of a property below its cost new. The principal influences are often grouped under three general headings and subdivided as follows:
- 1. Physical deterioration resulting from:
- a. Wear and tear from use;
- b. Negligent care (sometimes termed "deferred maintenance");
- c. Damage by dry rot, termites, etc.; or
- d. Severe changes in temperature.
- 2. Functional obsolescence resulting from:
- a. Poor architectural design and style;
- b. Lack of modern facilities;
- c. Out-of-date equipment;
- d. Changes in styles of construction;
- e. Construction methods and materials obsolete by current standards; or
- f. Changes in utility demand such as desire for master bath or more garage space.
- 3. External obsolescence resulting from adverse environmental and economic influences outside the property itself, such as:
- a. Misplacement of improvement (not typical for neighborhood);
- b. Zoning and/or legislative restrictions;
- c. Detrimental influence of supply and demand; or
- d. Change of locational demand.
The first two categories of accrued depreciation are considered to be inherent within the property and may be curable or incurable. The third category is caused by factors external to the property and is almost always incurable.
Appraisal and Income Tax Views - "Book" vs. Actual Depreciation
It is important to understand that "depreciation" is a word with two meanings: one for the appraiser and another for the owner concerned with tax position.
Book depreciation. Depreciation, for the owner's income tax position, is "book" depreciation, a mathematical calculation of steady depreciation from owner's original purchase price or cost basis. This "book" depreciation allows the owner to recover the cost of the investment over the "useful life" of the improvement. It accrues annually and is an income tax deduction. In this sense, the owner's accountant sees depreciation as a deduction from gross income.
Frequently, "book" depreciation results in negative gross income, at least on paper. The building seems to be losing value faster than the income replaces it. This gives the owner a "paper loss" that can be offset against other income. This "paper loss" or "tax shelter" is a motivating factor for purchase or exchange of many income properties.
"Book" depreciation is:
- an allowable deduction from cost for accounting or income tax purposes;
- determined by owner's policy and to meet IRS requirements; and
- deducted from owner's original (historic) cost.
"Book value" is the current value for accounting purposes of an asset expressed as original cost plus capital additions minus accumulated depreciation, based on the method used for the computation of depreciation over the useful life of the asset for income tax purposes. Depreciation is allowed on improvements only, not land.
The book value of the property may be ascertained at any given time by adding the depreciated value of the improvement to the allocated value of the land.
Actual depreciation. The "book" depreciation from owner's original cost is not the depreciation normally considered by the appraiser. The appraiser looks not to owner's original cost, but cost new on date of value. From this current cost new, the appraiser deducts the estimate of accrued "actual" (not book) depreciation. Depreciation (loss in value) is estimated only for improvements.
"Actual" depreciation used by appraisers is:
- loss in value;
- determined by market data, observed condition, etc.; and
- deducted from current reconstruction cost new.
Because accountants and appraisers select rates of depreciation for different purposes, accruals for book and actual depreciation vary considerably. While both estimators may use the same period as to the remaining economic life of the property and may also use the same method, additional considerations may affect the resultant rate. Whereas the accountant may be restricted because of accounting conventions, the appraiser is under no such restrictions.
The real estate agent who is determining values should understand the necessity for following proper appraisal procedures and should not rely on book values either to estimate accrued depreciation or for future depreciation accruals.