Depreciation is a difficult problem of accounting for costs of commercial real estate.

Accountants are fighting for a detailed budget, so we need a fundamental principle of the universe, occupied philosophers for thousands of years to achieve. As George Harrison sang years ago, “All Things Must Pass.”

There is nothing permanent in this world of three dimensions of space, time, matter and energy. Like all Buddhists.

No building is to last. The pyramids of Egypt one day erosion and dust.

Therefore, owners are entitled to expenses from gross income, known as depreciation on the theory that every year, building a little “worn to the wear of the universe is inferred. What physicists call entropy according to the third law of thermodynamics.

This depreciation is often calculated by dividing the total cost of construction for many years is expected to have a useful life calculated.

If you pay one million dollars for a building, and it is anticipated that over the last 10 years is a straight-line depreciation of $ 100,000 per year.

Note that $ 100,000 in cash paid out of pocket. Depreciation only reflects the reality that sooner or later, this building is not useful, so that the million dollars paid to disappear.

Although it is not possible, ideally you pay someone $ 100,000 per year for ten years to build a new building to replace it.

And if the loss of value by taking the basic construction costs significantly. Thus, after 10 years in the previous example, that the building is officially useless, but it might still be in good condition in a zone of prosperity. If properly maintained and in good range, can be useful for an indefinite period.

So, one major problem is deciding what the life of a commercial building.

Of course, when it comes to shopping, we assume that its function hire to make room for shops and restaurants, not to act as tourist attractions. Prevent can represent thousands of years by the Colosseum and the ruins of Angkor Wat – attract tourist dollars, even if I fell.

But even if the centers of the lower level of the building and the town band, but we do not know with certainty how long. Of course, there are castles in Europe hundreds of years – but also of stone farmhouses, where peasant families are still alive.

It is therefore quite possible to buy a building in a good area or building that the cost of depreciation on them. . . and 20 or 30 years are now much more value originally paid.

In a sense, reflects something real depreciation in the long term, but it is difficult to know how to do an annual fee – without a crystal ball.

For example, in New York the Empire State Building nearly 80 years, but it would be millions of dollars if sold. Life of the World Trade Center was a way that is not interrupted predictable.

Thus, if a Real Estate Investment Trust calculates net income is required to apply generally accepted accounting principles. Achieve gross revenues and then subtracting operating costs subtracted, then a significant amount, the depreciation of real estate is – even if you can, indeed, are appreciated in value.

Let’s say XYZ REIT revenue of $ 1,000,000 and operating costs of $ 700,000. This leaves $ 300,000. Then subtract another $ 100 000 for depreciation. This leaves $ 200,000 Net operating income.

The law requires that at least 90% of earnings to shareholders as dividends. Then you need Mail-$ 200,000 x 0.90 = $ 180,000 to its investors.

But wait – amortization of $ 100,000 is a “book” only. It is only on paper.

Operating expenses $ 700 000 in cash, the REIT to pay salaries next bank account, repairs and other necessary expenses.

Depreciation is not cash payments to third parties. The $ 100 000 is still sitting in your bank account.

Why not pay to its shareholders as well?

That would be $ 180,000 and $ 100,000 = $ 280,000 for dividends to shareholders, which makes them even happier.

Why not, indeed? This is what many of these companies – most in the form of dividends, which pay as required by law.

And get the dividends, as representatives of shareholders of the depreciation, it should be even happier than usual. Here’s why.

The share of dividend checks for real estate funds is the amount that is not immediately taxable to shareholders.

Why money is available because the company took a share of depreciation, according to the IRS, an official “return of capital and not income.

The return of capital is not passive, because it is not income. But the reduced cost from the REIT.

What is the moment that you care about the cost basis for their actions?

At the time of sale.

If you do not sell. . . You do not care for all.

Suppose you buy 100 shares of XYZ REIT for 10 € Your cost basis is $ 1000.

The first year is a new U.S. $ per share, 25 cents per share has been sinking. This means that you reduce your cost basis of 0.25 x 100 = $ 25.00.

So your base cost of 100 shares is now $ 975 instead of $ 1000

You must pay taxes on dividends, but only $ 75, not all $ 100.

If you decide next year to sell shares of the company for $ 11 each, the total would be $ 1100th Do I have capital gains on $ 125 instead of $ 100

In fact, you are now paying taxes, 25 cents per share dividend will check last year.

But we say they are smarter than that. They do not sell shares of XYZ. Just keep collecting the dividends, as long as you live.

If you pay tax on the depreciation rate? Never.

The consequences are little known or understood. Even the most famous author of REITs, Ralph L. Block, not in his book, the first REIT INVESTMENT mentioned annex.

The dividend yield of control of the capital of the reduction varies from company to company, and of course, vary over time. Historically, another 25% to 30%.

Confidence in the Fund’s shareholders the truth is that – its effectiveness, and net income after taxes are much higher than they think – not to sell their shares. The exact amount depends on your marginal tax rate.

Suppose in the example above, the marginal tax rate of 35%.

It is recommended that the normal tax of 0.35 x $ 75 = $ 26.25.

You are paid $ 100 and $ 26.25 in taxes, so a net after-tax $ 73.75.

Its net profit after tax of 7.375% shares.

If this were a normal society in some companies, dividends, real estate, you must pay $ 100 taxes on dividends, the total tax due of $ 35. For an income of $ 65. For a net return after fees of 6.5%.

Therefore, the real income of the provision to identify REITs, said that his performance is multiplied by (one more than the depreciation percentage X of the marginal tax rate).

Thus in the example above is the view of the performance of 10%. (A dollar of dividends for ten dollars of shares).

0.10 x (1 + ((0.25 x 0.35)) =

X 0.10 = 10.875% 1,0,875 thousands of tax returns

Purists will say that you are using the cost method of short stories, but my argument is that there is not so much that they sell the shares. In this case, the “practice” of the costs that you paid.

So, never sold.