A commercial building cost $2,500,000 to construct. The land value is $600,000. If the building has suffered 15% physical deterioration and 8% functional obsolescence, what is the depreciated cost of the improvements?
Correct Answer
B) $1,955,000
Why this is correct: the two forms of depreciation are applied in sequence, the second to what the first leaves. Calculation: physical $2,500,000 x 0.15 = $375,000, leaving $2,125,000; functional $2,125,000 x 0.08 = $170,000; $2,125,000 - $170,000 = $1,955,000. Why the other choices are wrong: $2,075,000 adds the two percentages to 23% and takes that off cost new, which is a larger deduction because it applies the second rate to the amount the first already removed; $2,125,000 stops after physical deterioration; $1,850,000 does not follow from either sequence.
Why This Is the Correct Answer
Option A correctly applies the sequential depreciation method. First, physical deterioration of 15% is calculated on the original building cost ($2,500,000 × 0.15 = $375,000), leaving $2,125,000. Then functional obsolescence of 8% is applied to this remaining value ($2,125,000 × 0.08 = $170,000). The final depreciated cost is $2,125,000 - $170,000 = $1,925,000. This method properly recognizes that depreciation factors compound rather than simply add together.
Why the Other Options Are Wrong
Option A: $2,075,000
This answer ($2,075,000) represents the value after applying only physical deterioration ($2,500,000 - $375,000 = $2,125,000) and then incorrectly subtracting a flat $50,000, suggesting the candidate may have miscalculated the functional obsolescence or applied it incorrectly.
Option C: $2,125,000
This answer ($2,125,000) represents the building value after applying only the physical deterioration ($2,500,000 - $375,000 = $2,125,000) but completely ignoring the functional obsolescence deduction.
Option D: $1,850,000
This answer ($1,850,000) likely results from incorrectly adding the depreciation percentages (15% + 8% = 23%) and applying the total to the original cost ($2,500,000 × 0.23 = $575,000), then subtracting from the original cost ($2,500,000 - $575,000 = $1,925,000). Wait, this doesn't match - this suggests a different calculation error.
Sequential Subtraction Method
Remember 'PFE-Sequential': Physical deterioration First, then Functional obsolescence, then External obsolescence - each applied sequentially to the remaining value, never additively to the original cost.
How to use: When you see multiple depreciation factors, immediately think 'sequential subtraction' - apply the first depreciation to original cost, then apply subsequent depreciations to the remaining value after each previous deduction.
Exam Tip
Always read carefully to identify ALL depreciation factors mentioned, and remember that land value is irrelevant to improvement depreciation calculations - focus only on the building cost.
Common Mistakes to Avoid
- -Adding depreciation percentages together instead of applying them sequentially
- -Including land value in the depreciation calculation when only improvements depreciate
- -Applying all depreciation factors to the original cost instead of the remaining value after each deduction
Concept Deep Dive
Analysis
This question tests the cost approach to valuation, specifically the calculation of depreciated replacement cost of improvements. The cost approach involves determining the current cost to construct the building, then subtracting all forms of depreciation to arrive at the depreciated value. Depreciation is applied sequentially, not additively - physical deterioration is calculated first on the total cost, then functional obsolescence is calculated on the remaining value after physical deterioration. This sequential application reflects how depreciation actually occurs in real property, where functional issues compound the impact of physical deterioration.
Background Knowledge
The cost approach requires understanding that depreciation must be applied sequentially, not additively. Physical deterioration affects the entire structure first, then functional and external obsolescence are applied to the remaining value. This reflects the reality that a building with both physical and functional problems experiences compounded value loss, not just the sum of individual depreciation factors.
Real-World Application
In practice, appraisers use this sequential method when valuing older commercial buildings where physical wear combines with outdated design features. A 1980s office building might have both roof deterioration (physical) and lack of modern HVAC systems (functional), with each problem compounding the other's impact on value.
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