Investing in commercial real estate is a significant financial undertaking. Maximizing after-tax cash flow from the real estate investment, especially in the early years of the investment, is typically a high priority. Therefore, when investing in commercial real estate for your own occupancy or for rental to others, you should take steps that maximize the income tax depreciation deductions that can be claimed for such property. Here are a few suggestions.
Separating 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. It is desirable to identify and document the part of your acquisition cost allocable to improvements at the time that 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. Or, 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 more the allocation to the improvements. Therefore, there is more potential for tax deductions. Whatever methodology you choose, it needs to be documented and defensible. Also, regarding the allocation, the cost of improvements includes not only the cost of buildings, but also the cost of items such as landscaping, roads, and even some costs of grading and clearing. A CPA 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.
Turning land into a deductible asset. Even though land isn’t depreciable, there are ways to obtain deductions for your land cost that provide a similar tax benefit. One technique is to enter into a long-term lease of the land rather than buy it. If you lease the land, the rents you pay under that “ground lease” are deductible. You and your CPA can decide together, in the case of any specific acquisition, whether a ground lease can be made to work for you, your lender, and the prospective landlord.
Use “Cost Segregation” to separate personal property from buildings. Most commercial buildings must be depreciated for tax purposes over a period of 39 years – that’s a long time! On the other hand, most personal property (furniture, equipment, etc.) is depreciable over considerably shorter periods. New personal property is eligible for additional first-year depreciation (bonus depreciation) equal to 50% 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. I.e., if a specific item is classified as personal property rather than as a part of a building, the depreciation deductions for that item will generally be available sooner. So, in economic terms it will have a greater “present value” to the property owner.
As it is desirable to properly allocate between improvements and land, it is equally important to take steps to identify and document items that are personal property and the items that are structural building components. This distinction follows common sense. For example, an ordinary chair is personal property (depreciable over 5 or 7 years), but a load-bearing brick wall is a structural component of a building (depreciable over 39 years). However, 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, can involve projections as to the future use of the items, and may even necessitate consultation with engineers or other construction experts. Also, 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 be a very powerful tool to accelerate depreciation deductions into the earlier years of a real estate investment. What’s even better is that the 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 did not have a cost segregation study performed 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, no need to amend seven years of prior tax returns. This special “catch-up deduction” can 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!
Consulting with your tax advisor can prove to be a financially wise decision prior to undertaking a commercial real estate acquisition. Investing in real estate is already an economically challenging proposition. Call us and don’t miss out on an opportunity to improve the economics of your real estate deal by turbo-charging your tax deductions.
Chris West, CPA, is a principal with Dalby Wendland in Grand Junction. He is a Colorado Mesa University graduate and began his career in public accounting in 1996. He specializes in mergers and acquisitions, real estate tax issues, real estate development, cost segregation studies, small business taxation, and consulting, tax, and estate planning for high net-worth individuals.
