Depreciated Book Value & Fair Market Value

It's All Greek to Me

The types of answers you get in financial services have a lot to do with the professionals that you’re talking to. There’s wisdom in the saying, “If all you have is a hammer, every problem looks a lot like a nail.”

Take the widely used concept in accounting, earnings before interest, taxes, depreciation, and amortization (EBITDA). Your financial advisor understands the final sums recorded on the balance; however, how the financials are spread can mean different things to different people. In real estate appraisal, we refer to EBITDA as net operating income or NOI. But what about instances where seemingly similar financial concepts are not the same? We’ve previously discussed the nuances with cost, value, and price. In our field, the concepts of depreciation and fair market values vary as do the processes for deriving and recording them.

depreciated Book Values & Balance Sheets

The IRS allows property owners to depreciate their real estate assets to decrease the tax burden incurred. However, the depreciated book value of an asset (the asset’s recorded value) is an income tax concept – its relevance for market value appraisals is limited at best. The depreciated book value is the historic cost associated with the initial purchase of the asset (cost basis) less cumulative depreciation. Put differently, the initial investment price, less physical common straight-line depreciation over a given time period.

Depreciation begins after the property is purchased, with the real estate values allocated as land (a non-depreciable asset) and the value of structures and improvements. When the property is sold, the stepped-up basis is calculated between the difference of the purchase price and the Fair Market Value. Capital gains – defined as the profit earned over the sale of an asset that has increased in value over the holding period – are taxed.

Assets aren’t depreciable in perpetuity. While the land is separated from the purchase of real estate (as it is not a depreciable asset), the real estate is only depreciable for the allowable legal limits. At the end of depreciation, the asset has limited book value from a tax perspective as the property’s tax benefits are assumed to have been maximized.

Fair market value

To establish the difference between an asset’s cost basis and stepped-up basis, the property’s Fair Market Value must be determined by a Real Estate Appraisal. In contrast to the depreciated value, the Fair Market Value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or sell and both having reasonable knowledge of the relevant facts (35 ILCS 105/3-10 Illinois General Assembly).

Every property has an expected useful life, with the long-term effects of physical obsolescence (depreciation) a certainty. Property improvements can cure physical obsolescence over the property’s lifetime; for example, roof repair/replacement, parking lot resealing, landscape/infrastructure updates and tenant buildout costs are expected. While a property’s actual age may be 50, its effective age, or estimated age based on its utility and physical wear, may be no more than 25 years.

Allocated book value Vs. highest & best use

For tax purposes, a book value for real estate is crucial. It quantifies the depreciation with the depreciated costs carried as an expense on an operational profit and loss statement. Depreciation effectively lowers profits, and as a result, reduces the tax incurred.

Although real estate assets are recorded separately as land and improvements, real estate appraisals follow the doctrine of highest and best use. Put simply; the real estate must be appraised subject to whatever yields the highest and best use of the property. The property is analyzed first as land alone and then as improved, with the highest and best use determined as the higher value. Often when there are vintage improvements on a property, the highest and best use of the property may very well be land value minus demolition (for the redevelopment of the underlying site), or building improvements sometimes lend themselves for repurposing.

different tools for different problems

To balance the books, separate estimates for the land and depreciated structures and improvements do the trick. However, in instances where a Fair Market Value appraisal is needed, Argianas always answers the call! Trying to find what your stepped-up cost basis exposure is? The Team at Argianas is here! Call us at 630.390.0113 or complete this form.