Accrued depreciation: physical deterioration and functional…

Accrued depreciation

Accrued depreciation is the loss in an improvement's value from any cause relative to its cost new as of the appraisal date. It is a valuation concept, not an income-tax deduction. In the cost approach, estimate land value separately, add the current cost new of improvements, and subtract accrued depreciation from the improvements. Land is not depreciated in this calculation, although its market value can fall.

Classify the cause

Physical deterioration is wear, damage, or decay: peeling paint, a leaking roof, or a worn foundation. Functional obsolescence is a loss caused by a deficiency or excess within the property relative to market expectations: an awkward floor plan, inadequate bathrooms, or an overimprovement whose cost buyers will not recognize. A new building can have functional obsolescence. External obsolescence, also called economic obsolescence, arises outside the property: nearby industrial noise or declining demand after a major employer leaves. It is generally treated as incurable by the individual owner. Classify the cause, not merely the symptom of lower rent or price.

Three branches identify physical deterioration as wear, damage, or decay; functional obsolescence as an internal deficiency or excess; and external obsolescence as an adverse outside influence. Physical and functional losses are tested for an economic cure: feasible correction costing no more than the value added. External loss is generally incurable. The distinct losses combine into accrued depreciation, which is subtracted from improvement cost new before separately estimated land value is added. — Identify the cause, test the cure, and subtract each loss once.

Decide whether a cure pays

Physical deterioration and functional obsolescence may be curable or incurable. A condition is economically curable when correction is feasible and its cost is no greater than the value added. A repair can be physically possible but economically incurable. Replacing worn carpeting for $4,000 when it adds $6,000 in value is curable physical deterioration; rebuilding a poor layout for $90,000 when it adds $30,000 is incurable functional obsolescence. Repair cost and value loss are not interchangeable in every case.

Measure the loss

The breakdown method estimates physical, functional, and external losses separately, avoiding double counting. If cost new is $400,000 and those distinct losses are $25,000, $15,000, and $20,000, accrued depreciation is $60,000. The improvements contribute $340,000; adding $100,000 land value produces a $440,000 cost-approach indication.

The simplified economic age-life method estimates depreciation as effective age divided by total economic life, multiplied by cost new. Effective age reflects condition and utility rather than calendar age. With effective age 10 years, total economic life 50 years, and cost new $400,000, depreciation is 20 percent, or $80,000. Remaining economic life is 40 years. These estimates depend on market evidence; age-life is a simplified model and should not be combined with separate deductions that count the same loss twice.

Accrued depreciation: physical deterioration and functional and external obsolescence