Congrats on your purchase.
For tax purposes, a commercial building is depreciable over 39 years (straight line, no acceleration) for the building portion (purchase price plus acquisition expenses, less a value allocated to the land on which it sits). At least that’s true if you don’t do anything to change it.
That’s quite a difference compared to the 27 ½ years for residential property.
Fortunately, you didn’t buy just a building and its land – unless perhaps you bought a shell building that you expect to build out.
You see, a functioning building is always made up of other components besides the foundation and walls, the permanent parts of the building purchase. It is also made up of land improvements, such as fencing, sidewalks, parking lots, and the like. These items are depreciable over just 15 years, and can be accelerated beyond straight line.
And, better yet, there generally is a good amount of personal property also purchased within the building, such as the overhead lighting, partitions, wall and floor coverings, communications wiring, electrical distribution systems, conduit/floor and power boxes, any special wiring for machinery, equipment, TVs, all kitchen piping, any personal property attached to or adjacent to the building, and more. These types of assets are allowed to be depreciated generally over 5 to 7 years, and because they are identified as personal property have other benefits such as bonus and accelerated depreciation.
The rule of thumb is that any building purchased in excess of $750,000 should be considered for breaking out the different ‘components’. I hesitate to use that word because that’s not what this is, although that word makes it easier to understand perhaps. This technique I refer to actually is segregating out the cost of the building and its improvements that qualify into their shorter lives for depreciation purposes.
After all, is it fair for you to depreciate the carpet, or any floor covering, over 39 years? Of course it isn’t.
So what’s next to get your best tax position?
As I see it, there’s three options for breaking out such items:
Hire an engineer to do a full study of the building and break out such ‘components’. If the engineer does a good job, and correctly allocates the aforementioned items, you would have no trouble with this matter in an IRS audit. Costs can range from thousands to tens of thousands of dollars, depending on the building.
Enlist a ‘cost segregation’ company to report to you what they recommend. These folks generally work off a percentage of tax savings, and therefore have become quite aggressive. There are many court cases where such companies have been “called on the carpet” so to speak for being overly aggressive, and some of their cost segregation studies have been overturned by the courts.
Rely on professionals around you, such as contractors, experienced commercial real estate agents, CPAs, and your own good judgment. Be conservative and real, and use common sense, and I have found that IRS auditors tend to believe that. For example, what would it take to replace that fence someday, then apply that cost of a new fence to your existing used fence, and make your best estimate. Paving the parking lot, pouring sidewalks, and improving other such areas would be costly, but you could get an estimate and add grading costs, then reduce that amount somewhat based on some wear and tear. The electrical distribution system and other personal property within the building may be a little more difficult, but electricians, contractors and other contacts you have could likely give you a pretty close estimate. The greatest risk here is that you would probably miss something, and have less tax deductions for depreciation than you might have with one of the other two options. However, if an audit did come about, and you hadn’t broken out all personal property or land improvements, then I’d suggest that you built in conservatism, and would be then less likely to have a challenge from the auditor.
This latter option may be viewed as a combination of options 3 through 6 suggested by the IRS in their own Audit Technique Guide. For specifics, go to:
Note one important IRS quote from the above:
“Neither the Service (IRS) nor any group or association of practitioners has established any requirements or standards for the preparation of cost segregation studies. The courts have addressed component depreciation, but have not specifically addressed the methodologies of cost segregation studies.”
Here’s an example of tax savings potentially available:
If real property is reclassified as 5-, 7- and 15-year personal property, it may qualify for 30% and 50% bonus depreciation. This bonus depreciation applies to new property in the first year it is placed in service. The magnitude of this additional allowance in the first year can be enormous. For example, a shift of $1 million from 39-year property to 5-year property can augment first-year depreciation deductions by a whopping $575,000 ($25,000 vs. $600,000). [example by Jay A. Soled, Journal of Accountancy]
Of even greater benefit since the above example was written, is the expense election option for personal property. As of 2016, that amount is at $500,000. It’s simple to calculate the first year’s potential tax savings in that scenario at a 30% tax bracket ($150,000)
None of the options is perfect, and each has its own advantages and disadvantages, which I think you can surmise. Whatever you decide to do, just do one of them if you want to improve your tax deductions for the first year, and for many years to come. [By the way, once you report the purchase price in the first year as a 39 year asset, it is more difficult to change that later on]
Scott C Turner CPA
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