Are you–like the majority of commercial building owners–overpaying your income taxes? Overpaying income taxes is common among real estate owners and investors because most are unaware that they are eligible for significant tax benefits available to them.
I’m talking about the option that the IRS makes available to commercial building owners to front-load the amount of depreciation expense they may take during the early years of ownership. This option exists because of a landmark court case settled in 1997 that forced the IRS to accept that commercial buildings contain a variety of asset types, including real estate and non-real estate assets with short depreciation lives.
If you are not taking advantage of this, here’s how to close this leak in your cash flow.
Because of the court case I mentioned (Hospital Corporation of America vs. Commissioner), buildings are no longer viewed by the taxing authorities as single assets, though that’s usually how they are set up on the balance sheet and depreciation schedule. No, the IRS recognizes that your commercial building may have a great deal of non-real estate assets in and around it.
The real estate consists of land (which is, of course not depreciable, since it does not wear out) and the building structure and basic systems, such as the plumbing, electrical, heating and cooling and so on.
Those non-land assets are properly depreciated over a long time period (39 years for commercial buildings, and 27.5 years for apartments).
But your building also contains many items that the IRS will allow you to write off over much shorter time periods, and if you do that you will decrease your income taxes and increase your after tax cash flow. If you missed out on this opportunity when you built or bought your building, the IRS even lets you catch up on missed depreciation deductions, without filing amended tax returns. In practice, this catching up can be done five, ten, or as long as fifteen years after you bought our built your property.
It depends on the type of building and what you have chosen to install, or what came with it when you bought it. But here are sample items from a recent cost segregation study my firm performed for the owner of an office building.
(These are just a few of over 200 separate items of personal property identified in the cost segregation study.)
These are some of over 30 separate assets outside the building identified by the cost segregation study.
In this particular case the total cost of the short-life assets within the building represented 25% of the overall cost of the property, exclusive of land cost.
As is often the case, the owner belatedly became aware of the opportunity to change the depreciation lives of these assets. After owning the property for five years he took advantage of the option to have a retrospective cost segregation study performed.
To better understand what I’m talking about, let’s walk through this example a step at a time.
The building in question was a multi-tenant office building with an initial cost basis (net of land cost) of $10,000,000.
When the building was acquired, the accountant had set it up on the balance sheet and depreciation schedule as a $10,000,000 asset (with an additional, separate amount for land, which has no bearing on this analysis). The standard depreciation life of 39 years for real estate was assigned to the improvements.
A cost segregation study was performed on the building five years after it was acquired. The study revealed that 15% of the initial improvements cost ($1.5 million) should be considered Personal Property with a five-year depreciation life, and 10% of the cost ($1 million) should be moved into the Land Improvements category, to be depreciated over 15 years. The remaining amount of $7.5 million was left as real property with a 39-year depreciation life.
The owner’s accountant used this information to recalculate the depreciation expense for each of three assets: building, land improvements, and personal property. Then the accountant filed a form with the IRS requesting permission for a change in accounting method for tax purposes. This form is automatically processed and accepted by the IRS.
From the beginning of Year 6, when the results of the study were applied, the property owner’s depreciation schedule reflected the correct depreciation lives and deduction levels. In addition, the owner was able to take a one-time catch-up depreciation deduction equal to the amount of “accelerated” depreciation that was missed during the prior five years.
Remember that all of the five- and fifteen-year assets were being depreciated too slowly, over 39 years. Although some depreciation expense had been recorded for those items, the amount of accumulated depreciation was far less than if they had been depreciated correctly, over five or fifteen years.
The “catch-up” depreciation deduction, taken in the year the cost segregation study was applied, adds this missed depreciation expense to the owner’s deductions, in one lump sum. That’s the beauty of a “lookback” study.
To see the effect of accelerated depreciation in action, take a look at the charts below.
Above, we see how the property’s straight line depreciation (red line), which was the situation before the cost segregation study, compares to the accelerated depreciation levels accomplished via the cost segregation study (blue line). The green line shows how much additional after-tax cash flow was generated for the owner due to the increase in depreciation expense recognized during the first five years.
Note, however, that I mentioned that the cost segregation study was done five years after acquiring the property, although the property owner could have applied cost segregation on Day 1 if they had known about it. How does the delay in applying cost segregation affect the outcome?
The next chart illustrates two after-tax cash flow patterns resulting from cost segregation.
On the left we see how, if applied at time of acquisition, the cash flow benefits of cost segregation would have occurred gradually during the first five years of ownership. The advantage of this scenario is that the extra cash flow would have been available to the owner sooner. On the right we see the “catch up” depreciation benefit expressed in after-tax cash flow, concentrated in the beginning of year six, roughly five years after acquisition and coinciding with the timing of a “lookback” or retrospective cost segregation study.
The total amount of additional cash flow over the entire five-year period would be comparable but, if applied retroactively, delayed, indicating some disadvantage depending on how much time value or rate of return the owner assigns to their money.
To summarize, cost segregation shifts depreciation expense to earlier years, creating additional cash flow that you can use for any purpose. It’s optimal to apply cost segregation immediately after acquisition or construction, but doing so retroactively is allowed without amending past tax returns and can be highly rewarding.
If you own and invest in commercial real estate, and have not yet looked into cost segregation, take a closer look to see if you can use it to significantly improve your cash flow. It’s easy to get a complimentary estimate of tax benefit that you can discuss with your tax advisor.
Learn more by reading/watching the following, then contact Jeff for a complimentary benefit analysis:
Jeff helps real estate owners increase their cash flow. He started his career as a Financial Analyst with the Irvine Company, and worked in various management/executive positions in the mortgage industry for many years. He's been a Cost Segregation consultant for several years and is considered one of the industry's top experts in TPRs. As Director of Business Development for Bedford Cost Segregation, Jeff helps his clients increase cash flow by accelerating their depreciation deductions, and by writing off assets that no longer need to be depreciated under recently changed tax rules. Jeff has a B.S. in Economics from Claremont McKenna College and an MBA with an emphasis in Finance from UC Berkeley.
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