Office building owners and their tenants have long understood the value of depreciation expense in relation to cash flow. Depreciation expense is a deduction that reduces taxable income and thereby increases after-tax cash flow. Generally, the shorter the depreciation period, the greater the tax benefit derived. Factoring in the time value of money, larger deductions over a short period of time are far more beneficial than smaller deductions over a long period of time. This is true even though the total amount of deductions is the same under both short and long depreciation periods. Front-loading deductions puts after-tax dollars in your pocket that can then be invested in something else or used to retire debt. Plus, there is an opportunity to increase those tax savings with certain tax incentives available only in 2009, such as the availability of bonus depreciation¹ and a five-year net operating loss carryback period.
Commercial rental property is generally depreciated for tax purposes over 39 years. Furniture and fixtures are depreciated over five or seven years. Land improvements, such as landscaping and parking lots, are depreciated over fifteen years. Leasehold improvement property is generally depreciable over 39 years; however, “qualified leasehold improvement property”² is depreciable over 15 years. Unimproved land is not depreciated.
COST SEGREGATION MAY LEAD TO GREATER CASH FLOW
If one could take a portion of a building that would normally be depreciated over 39 years and instead depreciate it over five or seven years, there would be a substantial and immediate tax benefit. That is where cost segregation comes into play. A cost segregation study identifies certain portions of what typically would be considered part of a building, and breaks them into tangible personal property asset classes with shorter depreciable lives. The result is faster depreciation on a portion of a long-term asset.
COST SEGREGATION STUDIES
Cost segregation studies can be performed on purchased buildings, newly constructed buildings and tenant improvements. Studies can be performed for buildings placed in service as far back as the mid-1980s. No amended returns are required to claim the additional depreciation. In 1999, the IRS announced that it would permit companies that have claimed less than the allowable depreciation in prior years to claim the omitted 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 might be claimed in the change year. The ability to claim several years worth of depreciation in a single year makes this a potentially lucrative tax benefit.
To take advantage of cost segregation allowances, you will generally need to hire an engineering or valuation firm specializing in cost segregation studies. Such firms make detailed inventories of individual assets to distinguish between items of personal property and items of real property. According to these firms, typically 20 to 40 percent of the costs can be reclassified.
Next, you will need a CPA to calculate the amount of additional depreciation and prepare Form 3115 (Application for Change in Method of Accounting), in order to claim the deduction on your tax return. A newly placed in service building or tenant improvement in the year of study would not require an Application for Change in Method of Accounting.
The study may not be beneficial to some owners. For example, if an owner is subject to the passive activity limitations of IRC Sec. 469, additional depreciation deductions may not be of immediate benefit. Losses disallowed under Sec. 469 are suspended and carried forward to a year in which there is passive income, or where the property is disposed of in a fully taxable transaction. Another consideration is depreciation recapture if the building is sold. If you are planning to sell your building within a short period of time, the benefits described could be reduced.
EXAMPLES OF BENEFITS FROM COST SEGREGATION STUDIES
PRE-EXISTING OFFICE BUILDING FOR THE TAXABLE YEAR 2009
A 200,000 square foot office building was purchased in 2003 for $30 million. Of that, $20 million was allocated to depreciable building improvements with a depreciable period of 39 years. The annual depreciation deduction was calculated to be $513,000. Therefore, between the years 2003 and 2008, $3,077,000 of depreciation expense was taken. A cost segregation study was performed for tax year 2009, and 20 percent of the depreciable cost was reclassified into 5-year property and 10 percent into 15-year property. The result would be a catch-up depreciation adjustment of approximately $4,000,000 against 2009 taxable income. In a 35% percent tax bracket, this depreciation adjustment would translate into a possible cash savings of $1,400,000.
A NEWLY CONSTRUCTED TENANT IMPROVEMENT PROJECT FOR THE TAXABLE YEAR 2009
A $6,000,000 leasehold improvement project (assuming not qualified leasehold) was completed during January 2009. Without a cost segregation study, the 2009 depreciation expense is $153,000. If a cost segregation study were performed and 20 percent of the construction costs were allocated into 5-year property and 10 percent of the construction costs were allocated into 7-year property, the total depreciation expense, without taking into account the bonus depreciation provisions, would then be $433,000. However, since bonus depreciation is available in 2009, the 2009 depreciation expense would be $1,170,000. This would be an additional $1,016,000 of depreciation expense in the first year alone. In a 35 percent tax bracket, the 2009 cash savings would be approximately $350,000. The benefi ts would be even greater if the leasehold improvements were qualified leasehold improvements that have shorter depreciable lives.
cost segregation study can be of enormous benefit in increasing cash flow to building owners. Such a study will identify the personal property components of a building, including land improvements, and thereby, allow you to claim faster depreciation. The catch-up of prior year depreciation under the faster depreciation system may be claimed as a deduction on your current-year return. If the additional depreciation deductions help to generate net operating losses in 2009, those losses may be increased by performing a cost segregation study. The potential tax refund could be maximized for those who are considering the 5-year net operating loss carryback claim.
Owners who have purchased, built or remodeled buildings placed into service as far back as the mid-1980s stand to realize substantial savings as a result of performing a cost segregation study.
¹ Bonus depreciation is an additional first-year depreciation deduction equal to 50% of the adjusted basis of qualified property.
² “Qualified leasehold improvement property” is the improvement made pursuant to a lease to an interior portion of a nonresidential building and the improvement is placed in service more than 3 years after the date the building was first placed in service by any person.
This publication contains information in summary form and is intended for general guidance only. It is not intended to be a substitute for detailed research nor the exercise of professional judgment. Neither BPM nor any member of the BPM firm can accept any responsibility for loss brought to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor.