TL;DR: While a building is being built, its costs are capitalised: added to the building's tax cost instead of deducted. Once it is ready to rent, that cost is depreciated: deducted bit by bit over 27.5 or 39 years.

Capitalisation: while you build. To capitalise a cost is to add it to the asset's tax cost (its “basis”) instead of deducting it this year. When a real estate fund develops a building, almost everything it spends during construction is capitalised: the hard costs, the fees and, under the uniform capitalisation rules, construction-period interest and property taxes too. No deduction yet. Land is never depreciated, so its cost sits in basis until the property is sold.

Depreciation: once it's ready to rent. Depreciation starts when the building is placed in service: finished and ready and available to rent, even if the first tenant hasn't moved in. From then on the capitalised cost comes back as a deduction, a little each year. Ordinary repairs are deducted as they happen, but improvements are capitalised and depreciated in their own right. A cost segregation study can carve out shorter-lived parts (fixtures, parking lots) that depreciate faster and can qualify for bonus depreciation. In a fund these deductions flow out on the K-1, often showing a tax loss while the property pays cash.

Residential vs commercial: 27.5 or 39 years. A residential rental building, where at least 80% of the rent comes from homes, is depreciated straight-line over 27.5 years. Offices, shops, warehouses and other commercial buildings take 39 years. Hotels count as commercial, because guests stay for short periods. An easy way to remember which is which: people live in an apartment around the clock, but only work in an office for part of the day, so the home wears out faster and gets the shorter life. That is a memory aid, not the legal test; the code simply sets the two periods.

Capitalise while building, depreciate once in serviceA timeline: during construction, costs are capitalised into the building's basis with no deduction. At the placed-in-service date the building is ready to rent, and depreciation deductions begin over 27.5 or 39 years.Building itRenting it outPlaced in service: ready to rentCapitalisecosts go into basisno deduction yetDepreciatehomes 27.5 years · commercial 39repairs deducted, improvements capitalised
Same money, different timing: capitalisation decides the cost, depreciation decides when you deduct it.

Worked example

A real estate fund buys land for $10m and builds an apartment block for $40m, paying $3m of construction-loan interest and $0.5m of property tax along the way. None of that is deducted during the build. The building's basis is $43.5m; the $10m of land is not depreciable. When the block is finished and ready to let, it is placed in service and the fund deducts about $1.58m a year ($43.5m ÷ 27.5), slightly less in the first year. Interest after that date is generally deductible as it accrues, subject to the Section 163(j) limit. Illustrative round numbers.

Where you'll see it: Development budgets and cost-to-complete reports, fixed asset registers, cost segregation studies, and the depreciation lines on real estate fund K-1s.

Code: IRC §§ 167, 168(c), 168(e)(2), 263(a), 263A; Treas. Reg. § 1.263(a)-3 · Related: Schedule K-1 (and K-3), REIT, Section 163(j)

See all 53 terms in the glossary

This glossary is general information, simplified for learning. It is not tax, legal or investment advice, and real structures turn on facts and documents not shown here.