In an ideal world, businesses with major capital assets would do an annual assessment of what percentage of the asset had depreciated in value and deduct that from their taxes. In practice, this is nearly impossible to do in a cost effective manner, particularly for commercial real estate ventures. As a result, there are several ways to calculate depreciation, ranging from the very simple (straight line depreciation) to the complex (Modified Accelerated Cost Recovery System). We'll cover each in turn.

Straight Line Depreciation takes an end term for depreciation (five years is typical), and divides the purchase cost by that number of years. Thus, if you spent $250,000 on a property, you'd be able to deduct $50,000 of that purchase price each year from your taxes for the next five years.

Straight Line Depreciation is a useful (and simple) approximation, but it's not always the optimum case. Accelerated Cost Recovery is a more complex form of depreciation allowed by the IRS, with numerous advantages. Most accelerated depreciation techniques use one of two methods of calculating depreciation; the aim is to front load more of the depreciation into the first year of ownership than into the latter years. This is an excellent tool if the item is exposed to the weather (as buildings are), or has routine rough use (as construction equipment gets). The two methods are Double Declining Balance (DDB) or Sum Of Years Digits (SOYD).

Double Declining Balance applies double the straight line depreciation percentage as a deduction to the remaining balance for each year of ownership. Thus, for a five year depreciation cycle, the first year would have (20*2) * 100% = 40%. Year two would have (20*2) * (100%-40%), or 24 %. Year three would depreciate at (20*2)*(100%-40%-24%) or 14.4%, year four would have 8.64% and year five, the last year of deduction, would have 5.18% deductions.

Sum Of Years Digits is a Ramanujan function, and uses the series of 1+2+3+4+5+(N+1) and so on., where the numbers in the sequence are the number of years allowed in the depreciation schedule. Thus, for a 4 year deduction schedule, it would get 1+2+3+4=10, and for a 5 year structure, 1+2+3+4+5=15, and for 6, 1+2+3+4+5+6=21. This is treated as the denominator (bottom half) of a fraction, where the numerator (top half) is a decrementing amount that starts with the number of years on the depreciation schedule, minus one per year. Thus, the first year of a 5 year schedule has 5/15=33% depreciation, the second year has (5-1)/15 = 26.67% depreciation, the third year has (5-2)/15=20% depreciation, with year four getting 13.33% and the final year getting 6.67%.

Both of these formats for calculating depreciation give you an extensive boost in your initial year's depreciation, and slowly taper off towards lower depreciation values towards the end of the term. However, to use accelerated depreciation of property values, you need to have an engineering study performed on the property that segregates the costs into four categories: Personal property, land improvements, building components and the actual land itself. These four categorizations allow separate depreciation schedules to be tracked. The typical schedules for the categorizations are:

Personal property is depreciated using a five or ten year recovery period, and the double declining balance methodology. Within reasonable bounds, there is a huge benefit to valuing the personal property as high as possible. This category mostly covers furniture, carpeting, fixtures and window treatments.

Land improvements typically have a useful life of fifteen to twenty years. They can use a declining balance method, but use a schedule of 150%, rather than 200% for determining the rate. This, like the first category, gives a benefit for declaring the value as high as possible. Typical examples of this sort of depreciated items include external decks and sidewalks, concrete pilings and docks.

The building itself should be broken down into individual components (roof, cellar, structural members, siding, interior walls, wiring) and depreciated individually by component. As always, maximizing the value on the initial purchase provides the most significant benefits. One side effect of component level itemization here is that any component that becomes worthless can be written off immediately, for a large cash flow influx.

Anything not accounted for in the first three categories is accrued as the value of the land. Land valued in this fashion may have a very low or insignificant value.

When cost segregation is begun, it's best to decide to do it at the time of purchase. Your accounting service will advise that you get an engineering report to annotate the depreciation schedules.

Tony Seruga, Yolanda Seruga and Yolanda Bishop of http://www.maverickrei.com specialize in commercial and investment real estate. As of May, 2006, they and their partners are managing over $600 million dollars worth of new projects