Real Estate Owner – Is your Tax Write-off worth less to you than the sum of its parts?
REAL ESTATE OWNER – Is your Tax Write-off worth less to you than the sum of its parts?
If you have purchased, constructed or rehabilitated a building over the past 5+ years you may be not writing off the cost of your building as fast as you could and you are paying higher taxes as a result.
Two significant tax planning strategies could in the year of your investment and in the future, lower your taxes significantly. Whether you are repairing or making an improvement is important to ask in the year of spending money on a building and carrying out a cost segregation study in the year of construction or even years after the fact could save you thousands in taxes.
Most buildings are worth more in tax deductions than the 1/27.5th or 1/39th per year that is allowed, on the surface, for residential or commercial real estate, respectively.
The first and generally easiest thing an owner of rental real estate can do is to look carefully at their expenses they pay to improve or repair their buildings.
If rehabilitating or fixing a building, a distinction needs to be made between improvements and repairs. Repairs can be deducted in the year spent but improvements are likely needed to be depreciated over as much as 27.5 years for residential buildings or 39 years for commercial structures.
The expense is an improvement and a depreciable asset, and not a repair if the expense results in the following:
- It materially adds to the value of the property, or
- It substantially prolongs the useful life of the property, or
- It changes the property to a new or different use
If any of the above conditions apply, then the expense is a capital expenditure and must be depreciated as an improvement. However, it just keeps the property in an ordinary efficient operating condition, then it can be expensed as a repair and is deducted in the year spent.
What is probably more significant is the ability to break the whole of a building into the sum of its parts via a Cost Segregation Study and potentially move up the buildings expense tax deductions from being made over 27.5 or 39 years as required for residential or commercial buildings, respectively.
What is a Cost segregation?
It is the process of identifying and reclassifying and segregating personal property, which has shorter depreciation lives, from the buildingʻs land and structural parts. Personal property includes a buildingʼs non-structural elements, exterior land improvements and indirect construction cost.
Which is better, depreciating over 27.5 or 39 years or 5 years? The shorter the period the bigger the depreciation deduction.
What are the basic structural component parts of a building?
- Foundation
- Basement
- Four outside walls
- The Load bearing walls
- A Roof to keep the outside environment out
Generally what is not a structural part of the building may likely be considered tangible personal property. In other words most of the stuff inside. The stuff that is capable of being moved without damaging the building structure and at substantial cost. Unfortunately determining what is and what isnʼt has been challenged by the IRS and States in the courts.
This is why all Cost Segregation Studies should be carried out by an Architect, Engineer or other cost-segregation specialist. Consequently when considering this strategy, the cost of the study must be compared with the tax benefits it could generate before charging forward.
All Cost Segregation Studies should include a detailed study of the buildingʼs walls, flooring, ceilings, plumbing, electrical, lighting, telecommunication, heating and cooling systems with a complete break out of the personal property compared to real property (i.e. the building itself and the land on which it sits).
The potential benefits are that you can maximize the tax savings by adjusting the timing of deductions to 5, 7, 12, or 15 years rather than 27.5 or 39 years. This can amount to thousands of additional tax deductions in the first 5 – 15 years of the tax life of the building rather than spreading the deduction over 27.5 or 39 years.
Some of the typical costs for non-structural elements are wall coverings, carpet, accent lighting, portions of the electrical system, exterior site improvements, etc.
An added incentive to consider a Cost Segregation Study is that it can also reveal opportunities to reduce real estate tax liabilities and identify certain sales and use tax saving opportunities.
The Cost Segregation Study Process is as follows:
I. The selection of an Architect, Engineer or other cost-segregation specialist
II. An over all assessment of building to identify potential for tax reduction if a study is carried out
III. In new construction or rehabilitation of a building, the actual breakdown of the construction elements needs to detailed
A. If Rehabilitating a building a distinction is to be made between improvements and repairs needs to be made:
1. Repairs can be deducted in the year spent
2. Improvements are likely to be depreciated
B. If not, but the expense merely keeps the property in an ordinary efficient operating condition – then can be expensed as a repair
IV. An engineering or architectural study of the drawings and components with a report should be issued
V. A depreciable life needs to determined for each non improved or new asset
VI. A final detailed report that will meet IRS scrutiny needs to be developed
A. Assets should be segregated info:
1. Personal property
2. Land improvements
3. Building components
4. Land
If you did not do a cost segregation study when you purchased, constructed or re-habilitated the building, you can still, after the fact, conduct a segregation study and file a change in accounting method with the IRS to correct the depreciation lives of the assets that are a part of the building.
Some references indicating typical Tangible Personal Property that can be segregated and depreciated faster that for the building structure itself:
• IRC Sec. 1245(a)(3) & Treasury Reg. 1.1245-3(b)(1) says the distinction between tangible personal property (i.e. that which can be depreciated less that 27.5 or 39 yrs.) and structural components should be based on the criteria once used to determine property qualifying for the repealed investment tax credit.
