Best Practices
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Found Money
I received a K-1 this morning and decided that the General Partner of our little group was a genius. Not only did we have good cash flow, but also we have a reportable loss for income tax purposes. After the euphoria subsided, I began to worry. Was this some accounting error? No, the General Partner had increased our tax benefits through depreciation allocation. His genius was to have a cost segregation study performed on the partnership property.
To learn more about this amazing tax benefit, I contacted Sook Lee, a CPA and Partner with Lee Miller, a Houston accounting firm that does tax planning for many real estate clients. Best Practices asked Sook to explain how to maximize depreciation on real estate. Sook provided the following advice.
Many property owners are not familiar with and have not been informed of the advantages of properly allocating values for depreciation purposes. The different depreciation schedules allocated by the IRS to the various property types can create a real tax savings. Here is the key, rather than lump the entire value of the improvements into a single value, there are advantages to allocating appropriate values to the many components that comprise the improvements. Those components with shorter lives will yield larger deductions. By examining all of the elements separately, there is an increase in the overall tax deduction.
For depreciation purposes, most real property falls into one of five basic categories.
- Land, which cannot be depreciated.
- Buildings and their structural components.
- Nonstructural fixtures.
- Personal property
- The goodwill associated with an operating business.
Commercial buildings and their structural components are depreciated over 39 years. Residential buildings, apartments included are depreciated over 27.5 years. These are the least favorable depreciation categories.
Nonstructural fixtures can be depreciated at 15 years. Personal property depreciates over 7 years and computer systems depreciate over 5 years. The goodwill associated with a project depreciates over 15 years.
If you inventory and assign values to the various components of a project, the rate of depreciation can be greatly increased. Many people assign a magic percentage, such as 15 to 25% of the total project value to the land and the remainder to the buildings. Further analysis will most likely yield more tax advantageous allocations.
Look closely at the land. How much of the land value is raw land and how much of it is land improvement? Land improvements will vary with each property. Items included in land improvements and depreciable over 15 years:
* Drainage systems
* Sidewalks
* Curbs
* Fences
* Gates (less anything operated by a computer)
* Signs
* Driveways
* Roads
* Parking spaces
* Landscaping
* Sprinkler systems
* Outside lighting systems
Since buildings and their structural components receive the least favorable depreciation treatment, these need to be valued in the strictest sense. Often, it is easier to determine the value of the non-structural fixtures and personal property, and back into the value of the building and structural components.
Personal property can include office furniture, carpeting, maintenance tools, pool equipment, window coverings, some appliances etc. Most owners can readily identify the personal property.
Non-structural fixtures become more creative. I have seen doors on mini warehouses, alarm systems; exterior and interior paint, roofs, window screens, mirrors and light fixtures listed as non-structural fixtures. With proper documentation lease space build out can be put on the non-structural depreciation fast track.
If the building is being constructed, it is a good record-keeping practice to require the general contractor to bill on a specific basis versus billing on a lump-sum basis.
In recent months, Goodwill has drawn a lot of media attention with high profile companies being scrutinized. Goodwill is the value of a business or property beyond the value of the physical land and building. It is the value assigned to being an on going concern. Advertisement and branding can be a large part of this value. The IRS has developed specific methods of determining the value of Goodwill. The goodwill component is usually calculated by a CPA. Some appraisal firms specialize in depreciation allocation.
After talking with Sook, I call a Randy Nicholson. Randy heads the Cost Segregation Analysis department for O’Connor and Associates, a Houston based Appraisal Company, with offices nationwide, that specializes in depreciation allocations or cost segregation studies for commercial real estate.
BP: Randy, could you tell us what your company does?
Randy: O’Connor and Associates performs a cost segregation study and prepares a report for the owner. The report sets out an accurate allocation of the various property components for federal income tax depreciation calculations.
In preparing the report, our appraiser inspects the property and identifies all the items that are eligible for depreciation, and allocates these items to the appropriate depreciation term. This is very specific; allocations are based on IRS rules and a series of court decisions. For example, carpeting and vinyl tile has a 5-year depreciable life. Ceramic tile is longer. We appraise thousands of properties annually and remain ever diligent of the nuances of the depreciation lives of property components.
The completed report is given to your CPA who incorporates the schedules into your income tax return. Since we do not have state income tax in Texas, we tend to only think in terms of federal income tax, but this can also be used for state income tax purposes.
BP: What is the difference in accelerated depreciation and increased depreciation using cost segregation?
Randy: In using cost segregation, you increase the amount of depreciation by accurately allocating the correct value and the correct life of each separate component of the property. Once each component’s value and the life are established, the owner can elect either straight-line depreciation or accelerated depreciation.
Many taxpayers elect not to use accelerated depreciation since it often triggers Alternative Minimum Tax (AMT) treatment. However, when cost segregation is used with the straight-line depreciation method, it has the effect of increasing the initial depreciation deductions without using accelerated depreciation. Therefore, it does not lead to the AMT tax treatment, nor does it trigger audits. This is a valid deduction that continues year after year. The biggest tax savings occur in the first five years.
BP: Are appraisers that specialize in this field also able to set a value for goodwill?
Randy: Goodwill requires a whole different approach. We have the ability to make that determination. We only value the goodwill component if the client specifically requests it. Usually we are able to achieve such significant savings on the standard cost segregation report that goodwill is not addressed. Goodwill is also more difficult to prove to the IRS.
PB: This sounds great for new purchases, but what about properties already on an amortization schedule?
Randy: If you bought or built an improved investment property since 1988, you can benefit. Note, this does not apply to your home or to raw land, but rental-houses do qualify. Even if there is an existing depreciation schedule, we can usually increase the tax savings with a cost segregation study.
PB: What can I expect to save using this method?
Randy: Savings vary with each property and depends on the ownership entity’s tax rate. The first year tax savings for a recent assignment was $10,000 on a $1 million apartment project. Another owner enjoyed a $20,000 tax savings on a $4 million office building.
BP: When is the ideal time to do this study.
Randy: As early in the project as possible. If you are planning a development project or a renovation, we may be able to increase the tax savings by looking at your plans prior to construction and making recommendations. This allows you to design tax savings up front.
BP: Thank you, Randy. I’m sure that our readers will find this information very valuable.
In closing, firms performing this service usually are hired on either a flat fee basis, or a percentage of the tax savings realized by the client. Like most service providers, the cost will vary depending on the property type, the amount of documentation required by the client, and the amount of travel required to perform the assignment.
If you want to increase cash flow through reduced taxes, you owe it to yourself to explore the possibility of increased depreciation deductions using cost segregation. Its like found money!
For additional information, Sook Lee is available at sook@millerlee.biz and Randy Nicholson’s e-mail address is rnicholson@poconnor.com.
“Best Practices” is written by Vicki Yeomans. Ideas for future topics should be sent to vyeomans@swbell.net.
