If you are in the renovation or construction phase of an office building or have owned an office building for several years, there is an important question that you need to review relating to the depreciation of the building and components. What time frame are my assets being depreciated over?
Office building owners and tenants have long understood the tax benefits that depreciation has on the cash flow of the business or rental. Depreciation expense is a deduction that reduces income and thereby increases cash flow. The shorter the depreciation period, the quicker the tax benefit is derived. Commercial real estate is generally depreciated over 39 years, personal property such as furniture and fixtures over five or seven years, land improvements over 15 years — and the land costs are not depreciated. A review of the components of the building needs to be performed to ensure that the shortest depreciation periods allowed are used. Often, these reviews are performed as a cost segregation study.
If you could take a portion of a building that would normally be depreciated over 39 years and instead depreciate that portion in five or seven years, there would be an immediate and substantial tax benefit. Several items that are normally classified as “part of the building” can be determined to have shorter lives attributed to them. For some items, the distinction follows common sense. For example, an ordinary desk is personal property where a load-bearing wall is part of the building. However, for many items such as lighting fixtures, signs, floor coverings, plumbing, electrical systems and cooling systems, the distinctions are governed by tax rules that can be complex and can involve projections as to the future use of the items. These may also require consultation with engineers or other construction experts. An example of this is the special electrical system that must be added to power the use of equipment such as radiology imaging machines. To the extent that the electrical system is specially allocated to running such equipment, that portion of the electrical can be depreciated over seven years as part of the machinery versus the 39 years if left as “part of the building.” Also, after the personal property and building items have been separately identified, you must value them with either an appraisal or a breakdown of the construction costs or both. The obvious benefit will be that your depreciation deduction will be larger, which in turn increases cash flow for operating needs or other investment opportunities.
These cost segregation studies can be performed for buildings and improvements placed in service as far back as the mid 1980s. There is no need to amend returns in order to claim the additional depreciation. In 1999, the IRS announced that it would permit those who have claimed less than the allowable depreciation in prior years to claim the recalculated (or missed) depreciation as a change in accounting method. In 2002, the IRS announced that all of the prior years’ depreciation that is allowable under a cost segregation approach could be claimed in the change year.
This ability to claim several years’ worth of depreciation in a single tax year can produce a potentially huge benefit. You will need to have your CPA calculate the additional depreciation and file Form 3115, Application for Change in Accounting Method, in order to claim the deduction on your tax return. A newly placed in-service building or tenant improvement in the year of the cost segregation study would not require the Form 3115 to be filed.
Not all buildings or renovations will benefit from a cost segregation study. For example, if an owner is subject to passive activity limitation of IRC Sec. 469, the additional depreciation deductions would not lead to immediate reduction in taxes due. Passive activity losses that are disallowed under IRC Sec. 469 are suspended and carried forward to a year in which there is passive income or there is a disposition of the entire property in a taxable transaction. Also, if you are planning to sell the building in the near future, say three to five years, the benefits of the cost segregation study will be reduced due to the depreciation recapture provisions of the tax code.
As with most decisions relating to provisions in the tax law, there are very few cut-and-dried answers. You will need to analyze the cost versus benefit of the cost segregation study to determine if the cash flow warrants moving forward with the study. Always keep your team of professionals informed as to your wishes and opportunities to make sure you are getting the proper advice and guidance.
Jeff Jackson, CPA, is a shareholder at Sol Schwartz & Associates, PC. Jeff has been a certified public accountant since 1992 and has been in public accounting since 1990. Jeff focuses on all areas of taxation and financial planning, including individual, partnership and corporate income taxation, along with estate, gift and retirement planning. He relies on his business and investment experience to identify the many issues his clients may face, particularly in working with high net-worth individuals, their families and closely held businesses. Contact Jeff at 210-384-8000, ext. 144, or via email at firstname.lastname@example.org.