Depreciation: A Building That Only Ages on Paper

Some actors play the same age on screen no matter how many years pass. A series can run for twenty years, and the character’s stated age never moves. The actor is visibly aging; the person on the page never does. The age on paper (the script) and the actual age run on entirely separate tracks.

A building’s account books perform a similar trick — in the opposite direction. A real building, well maintained, can actually gain in value: better location relative to its surroundings, rising rents, appreciating worth. But on the books, it dutifully ages a little every single year. This aging that happens only on paper is depreciation.

Why call something old when it isn’t aging at all

Tax law’s logic runs like this. It treats a building as an asset that, like machinery or a car, wears down over time and will eventually become unusable. So tax authorities divide the building’s price across a set period (for commercial buildings, typically somewhere around 30–40 years, varying by country) and let the owner recognize that portion as an “expense” every year. Just as a company that buys equipment expenses the machine’s wear each year, a building owner also deducts, each year, an amount representing “this much of the building wore away.”

The key point is that this expense isn’t money actually leaving anyone’s bank account. Depreciation leaves no trace in a bank account at all. It’s just a number that gets stamped on paperwork filed with the tax office — “the building’s book value fell by this much this year.” The real building, meanwhile, might have gotten a fresh coat of paint, a renovated lobby, happier tenants, and rent that actually rose from last year. On paper, the building ages; in reality, it may be getting younger. That contradiction is the whole essence of depreciation.

What happens on the tax bill

This paper aging matters because it actually reduces taxes. Recall NOI (Net Operating Income) from the previous chapter — it only captures line items where real cash changes hands. But when it comes to calculating taxes, the story changes. To calculate “taxable income” for tax purposes, depreciation gets subtracted from NOI one more time — and this is a purely paper deduction, not money that’s actually going anywhere.

Say a building’s NOI is $100,000, principal repayment on the loan eats $30,000, and depreciation is booked on paper at $40,000. The cash that actually ends up in the owner’s hands is roughly $70,000 (NOI minus debt service). But the taxable income reported to the tax office is $60,000 ($100,000 minus the $40,000 depreciation) — or possibly even lower. This means the basis on which tax is assessed (taxable income) can end up lower than the cash actually pocketed (cash flow) — you can genuinely be making money while your paperwork makes it look like a loss.

This is exactly why real estate has long been called a “tax-advantaged asset.” In exchange for a building pretending to age on paper, there can be stretches where cash is coming in even as taxes owed shrink. But this isn’t free. Most tax systems have a procedure for later “recapturing” that accumulated paper depreciation and taxing it when the building is eventually sold. The bill for aging deferred on paper arrives all at once, at the moment of sale.

What “ideal” looks like

Tax professionals describe an ideal picture like this: when depreciation exceeds principal repayment, you avoid the worst-case scenario of being taxed on cash you don’t actually have in hand. Conversely, when principal repayment exceeds depreciation, you get the unfavorable combination of cash steadily leaving your account (to pay down the loan) while taxes are reduced by less than that amount.

The trouble is that this balance shifts every time tax law changes. In the United States, for instance, the depreciation period for commercial real estate was 15 years (a 6.3% annual write-off) in the early 1980s; subsequent legislative changes stretched it out to around 39 years for commercial property, shrinking the annual depreciation rate to roughly 2.5%.[1] The longer the depreciation period, the smaller the annual slice of paper aging you’re allowed to claim, and the thinner the tax benefit becomes. These specific figures and rules vary by country and by era, and will keep changing. What matters isn’t memorizing a particular number — it’s understanding the underlying structure: the pace of paper aging is set not by the building’s actual condition, but by that year’s tax code.

The same magic trick on a REIT’s books

This paper aging shows up especially dramatically at REITs (Real Estate Investment Trusts). A REIT bundles multiple buildings and sells shares in them like stock, and its accounting net income often paints a strange picture. Even when the buildings it holds are genuinely seeing rents rise and values climb, depreciation can eat so deeply into net income that the books show something close to a loss. This is exactly why the REIT industry invented its own separate metric: FFO (Funds From Operations), which adds depreciation back to net income to show “how much real cash is actually left.” It’s essentially restoring the age that was shaved off on paper, to measure real physical condition. The fact that the REIT industry had to invent an entirely separate metric is itself proof of how far accounting depreciation can drift from reality.

Tax benefit and real value are two different stories

There’s a trap worth flagging here directly: the tax benefit that depreciation creates and a building’s real value are two completely separate stories. Depreciation is purely a tax-calculation device; it has nothing whatsoever to do with whether a building is actually getting worse or better. A landmark office tower in downtown Tokyo and an aging warehouse on the outskirts of Lima might be subject to the exact same tax depreciation schedule, yet the paths their real value travels can be entirely different. One might see rents and price tags climb over time; the other might genuinely be deteriorating, requiring constant capital expenditure. The paperwork says both are “aging at the same rate every year.” Reality says otherwise.

Missing this gap leads to two common mistakes. One is assuming, “I’m saving on taxes through depreciation, so this building is a good deal.” The tax benefit is a bonus, not the substance of the investment. What matters first is whether the building is actually collecting rent, and whether that rent has room to grow. The other mistake runs the opposite direction — worrying that “the depreciation figure on paper is large, so this building must be about to become unusable.” The size of a depreciation deduction simply follows the schedule set by tax law; it has nothing to do with the building’s actual remaining lifespan.

There have been periods in history when this gap grew far too wide. During eras when tax benefits were especially generous, plenty of real estate that was genuinely cash-flow positive still generated paper losses used to offset other income. Investment decisions were driven less by a building’s underlying economics than by “how do we make use of this loss for tax purposes.” As depreciation periods later lengthened and loss-offset rules tightened, this structure largely faded, leaving tax-exempt institutional investors — pension funds, for instance, which never owed taxes in the first place — relatively better positioned.[2] It’s both a lesson in how tax policy can distort the substance of investing, and a reminder that investing driven by a building’s real economics outlasts investing chasing tax benefits.

Don’t trust the paperwork — look at the building

The conclusion here is simple. Depreciation is a useful tax tool, not a health checkup for a building. When reviewing a listing, it’s worth knowing how much depreciation is being claimed — but you shouldn’t use that number to judge the building’s true condition. The real questions lie elsewhere: Is this building actually deteriorating, or actually improving? Will tenants keep wanting to be here? The answers come not from the tax office’s depreciation schedule, but from the neighborhood the building stands in and what’s actually happening inside it.

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Sources

• The definition of depreciation (a paper aging process unrelated to cash flow) and the structure behind calculating CFO and taxable income: adapted from William J. Poorvu with Jeffrey L. Cruikshank, The Real Estate Game (Free Press, 1999)
• The concept of depreciation recapture and the applicable tax-rate structure: adapted from William J. Poorvu with Jeffrey L. Cruikshank, The Real Estate Game (Free Press, 1999)
• The background behind REITs’ FFO (net income plus depreciation added back) as a metric designed to correct for depreciation distortion: adapted from William J. Poorvu with Jeffrey L. Cruikshank, The Real Estate Game (Free Press, 1999), see Chapter 15 (REITs) of this volume.
• [1] US tax-law changes (depreciation period expanding from 15 years to 39/27.5 years, annual depreciation rate shrinking from 6.3% to roughly 2.5%, cited for historical reference only): adapted from William J. Poorvu with Jeffrey L. Cruikshank, The Real Estate Game (Free Press, 1999)
• [2] How tax-benefit-driven investment structures contracted following the 1980s expansion of depreciation periods and tightening of loss-offset rules, and how tax-exempt institutional investors gained relative advantage as a result: adapted from William J. Poorvu with Jeffrey L. Cruikshank, The Real Estate Game (Free Press, 1999)