We’re delighted to offer this informative article on Cost Segregation by Chris West, CPA, a principal at Dalby, Wendland & Co., a full-service auditing and accounting firm in Grand Junction, CO. This article was first printed in The Business Times.
Investing in commercial real estate represents a significant financial undertaking. Maximizing after-tax cash flow, especially in the early years of the investment, is typically a high priority. Whether investing in commercial real estate for your own occupancy or to rent to others, take steps to maximize income tax depreciation deductions that can be claimed for such property.
Here are a few suggestions:
Separate improvements from land. Not all of the cost of acquiring real estate is depreciable. The cost of improvements to land is depreciable, but the cost of the land itself is not. Identify and document the part of your acquisition cost allocable to improvements at the time you acquire real estate.
When you buy a property, retain a qualified real estate appraiser to make an allocation between land and improvements based on a detailed written analysis. If you have enough valuation expertise and knowledge of the locality, write your own detailed analysis and allocation. At a minimum, information from the county assessor’s website can provide guidance as to the allocation between land and improvements. Remember, the lower the allocation to land, the higher the allocation to improvements and potential for tax deductions.
Whatever method you choose, it should be documented and defensible. Regarding the allocation, the cost of improvements includes not only the cost of buildings, but also the cost of such items as landscaping, roads and even some grading and clearing. A certified public accountant can assist an appraiser or you in identifying which of these seemingly land-related costs are costs of improvements and should be reflected in the improvements portion of the allocation.
Use cost segregation to separate personal property from buildings. Most commercial buildings must be depreciated for tax purposes over 39 years. That’s a long time. On the other hand, most personal property — such as furniture and equipment — is depreciable over considerably shorter periods. New personal property is eligible for additional first-year depreciation (bonus depreciation) equal to 50 percent of its cost and, for some taxpayers, up to $500,000 of immediate write-offs. In contrast, among buildings or building improvements, only certain building improvements are eligible for bonus depreciation and/or immediate write-offs. If a specific item is classified as personal property rather than part of a building, depreciation deductions for that item are generally available sooner and offer greater present value to the property owner.
Just as it’s important to properly allocate between improvements and land, it’s equally important to identify and document items that are personal property and items that are structural building components. This distinction usually follows common sense. An ordinary chair is personal property depreciable over five or seven years, but a load-bearing wall is a structural component of a building depreciable over 39 years. For many items such as lighting fixtures, signs, floor coverings, wall coverings, plumbing, electrical systems and heating and cooling systems, the distinctions are governed by tax rules that can be complex, involve projections as to the future use of the items and could even require consultation with engineers or other construction experts. After the personal property and building items are separately identified, they must be separately valued, either by an appraisal, a breakdown of construction costs or both.
The process of separating personal property items from the structural building components is commonly referred to as a cost segregation study. A cost segregation study can offer a powerful tool to accelerate depreciation deductions into the earlier years of a real estate investment.
Even better, tax rules allow you to obtain the benefits of a cost segregation study even for buildings acquired or constructed in a prior year. Let’s say you constructed a commercial building seven years ago, but didn’t conduct a cost segregation study at that time. Today, a look-back cost segregation study could be performed to catch up the accelerated depreciation deductions missed over the last seven years. That’s right, there’s no need to amend seven years of prior tax returns. This special catch-up deduction may be claimed by filing for a change in accounting method and deducting the full amount in the current tax year. Now that’s having your cake and eating it too.
Consult with your tax advisor before undertaking a commercial real estate acquisition. Investing in real estate is already an economically challenging proposition. Don’t miss out on an opportunity to improve the economics of your deal by turbocharging your tax deductions.
Thanks again to Chris for his permission to reprint this article. If you’re interested in how you can benefit from a cost segregation study, consider requesting a complementary cost benefit analysis from the NorCal Valuation office.
For more information about Dalby, Wendland & Co., which opened its doors in downtown Grand Junction in 1948 and is now entering its 63rd tax season, use this link.