Depreciation is a difficult subject in the area of cost accounting for commercial real estate.

Accountants do strive to make their financial statements accurate, and so they must recognize a fundamental principle of the universe that has troubled philosophers for tens of thousands of years. As George Harrison sang years ago, “All Things Must Pass.”

There is nothing permanent in this three-dimensional world of space, time, matter and energy. Just as any Buddhist.

No building will last forever. Even the pyramids of Egypt will someday erode into dust.

Therefore, real estate property owners are allowed to deduct an expense from their gross income, called depreciation, on the theory that every year, the building is being worn down somewhat by the wear and tear of the universe. What physicists call entropy, according to The Third Law of Thermodynamics.

This depreciation expense is often calculated by dividing the total cost of the building by the number of years it’s expected to have a useful life.

If you pay one million dollars for a building, and it’s expected to last 10 years, that’s a straight-line depreciation expense of $100,000 per year.

Notice that $100,000 in cash is not actually paid out of your pocket. Depreciation simply reflects the reality that sooner or later, that building won’t be useful, and so the $1,000,000 you paid will be gone.

Although this is not practical, the ideal would be for you to pay someone $100,000 a year for ten years to build you a new, replacement building.

And when you take the depreciation expense, that is also deducted from the building’s cost basis. So after 10 years, in the above example, that building is officially worth nothing, even though it may still be in great condition in a prosperous neighborhood. If it’s well-maintained and in a good area, it can be useful for an indefinite period.

So one of the big problems is deciding what the useful life span of a commercial building is.

Of course, when we’re talking about shopping malls, we’re assuming their function is to lease space out to retail stores and restaurants, not to act as tourist attractions. So we can rule out multi-thousand year old spans such as represented by the Coliseum of Rome and the ruins of Angkor Wat — which attract tourist money even though they’ve fallen down.

Yet even when we come down the level of commonplace apartment building and shopping strip centers, we just don’t know for sure how long they’ll last. Sure, there’re castles in Europe hundreds of years old — but also stone farm houses where farming families still live.

So it’s entirely possible for a building in a good area to be bought or built, to have the depreciation expense taken on them . . . and 20 or 30 years later they’re now worth far more than you originally paid.

So, in a long-term sense, depreciation reflects something real, but it’s difficult to know just how much of an expense to take every year — without a crystal ball.

For example New York City’s Empire State Building is nearly 80 years old, but would be worth many millions if sold. The World Trade Center’s useful life ended prematurely in a way that couldn’t be predicted.

So when a Real Estate Investment Trust calculates its net income, it is required to apply Generally Accepted Accounting Principles. It will figure out its gross revenues, then subtract its operating expenses, then subtract a substantial figure representing depreciation on the buildings it owns — even though they may in fact have appreciated in value.

Let’s say XYZ REIT had gross revenues of $1,000,000 and operating expenses of $$700,000. That leaves $300,000. Then they deduct another $100,000 for depreciation. That leaves $200,000 as their net operating income.

The law requires them to pay at least 90% of this to their shareholders in the form of dividends. So they must mail out $200,000 X .90 = $180,000 to their investors.

But wait — the $100,000 depreciation expense is a “book entry” only. That is, it’s only on paper.

The $700,000 operating expenses represent cash that left the REIT’s bank account to pay for salaries, repairs, and other necessary expenditures.

Depreciation does not represent a cash payment to anybody. That $100,000 is still sitting in their bank account.

So why not pay it out to their shareholders also?

That’d be $180,000 plus $100,000 = $280,000 available for dividends for shareholders, making them even happier.

Why not, indeed? That’s what many of these companies do — pay out more in dividends that the law requires.

And receiving some dividend payments that represent depreciation should make the shareholders even happier than usual. Here’s why.

The percentage of the dividend checks they receive from real estate investment trusts that represents depreciation is not immediately taxable to shareholders.

Because it represents money that’s available only because the company took a depreciation expense, according to the IRS it’s officially a “return of capital,” not income.

A return of capital is not taxable because it’s not income. But it does reduce the cost basis of your REIT shares.

When is the only time you care about the cost basis of your shares of stock?

When you sell them.

If you don’t sell them . . . you don’t have to ever care.

Let’s say you bought 100 shares of XYZ REIT for $10 each. Your cost basis is $1000.

In the first year got a dollar back for each share, of which 25 cents per share was for depreciation. Which means your cost basis is reduced by .25 X 100 = $25.00.

So your cost basis in those 100 shares is now $975 instead of $1000.

You do have to pay taxes on the dividends, but only on $75, not the full $100.

If next year you decide to sell the shares of stock for $11 each, you’d get a total of $1100. You’d owe capital gains taxes on $125 instead of $100.

In effect, you’re now paying the taxes on that 25 cents per share depreciation in dividend checks you received the year before.

But let’s say you’re smarter than that. You don’t sell your shares of XYZ. You just keep collecting the dividends for as long as you live.

When do you pay taxes on the depreciation percentage? Never.

The implications of this aren’t widely known or understood. Even the best known REIT book writer, Ralph L. Block, doesn’t mention this in his book INVESTING IN REITS until the first Appendix.

The percentage of dividend checks that represent return of capital because of depreciation varies from company to company, and can of course vary over time. Historically, it runs 25% to 30%.

The bottom line for real estate trust shareholders is that — if they never sell their shares — their effective, net after-tax yields are significantly higher than they think. The exact amount depends on their marginal tax rate.

Let’s say that in the above example, your marginal tax rate is 35%.

You’ll owe ordinary taxes of .35 X $75 = $26.25.

You received $100, and paid $26.25 in taxes, leaving you with an after-tax net of $73.75.

Your after-tax net yield on your shares is 7.375%.

If this was an ordinary dividend-paying company in some business besides real estate, you’d have to pay taxes on the entire $100 in dividends, for a total tax owed of $35. For a net of $65. For a net after-tax yield of 6.5%.

Therefore, to figure out the true net, after-tax yield of a REIT, you must multiply its stated yield by (one plus the depreciation percentage X your marginal tax rate).

Thus, in the above example, the apparently yield is 10%. (One dollar in dividends for ten dollars worth of stock).

.10 X (1 + ((.25 X .35)) =

.10 X 1.0875 = 10.875% net after tax yield

Purists would argue that you should use the new cost basis, but my argument is that it’s irrelevant so long as you never sell the stock. In that case, your “practical” cost basis is what you originally paid for it.

So never sell it.