Two Birds, One Stone: Leverage Tax Benefits and Write Off All Impaired Assets
Over the past several years, the use of cost segregation studies as a means of lowering income taxes has gone from being a niche practice utilized by the savviest of real estate investors to an almost standard part of purchasing commercial properties, whenever applicable. This has come about for two reasons.
First, the increase in boutique service providers has allowed greater market coverage. In the past, only the larger accounting firms offered this service to their clients. The opening of exclusive, cost segregation-only practices has allowed even the smallest property owners to reap the benefits of a cost segregation study. Additionally, general industry knowledge of the concept—that of merging the combined specialties of engineering and tax accounting to accelerate the depreciation of commercial real estate—has continuously increased via networking, social media and educational seminars at real estate industry conferences.
Despite its increase in understanding and popularity, there is one aspect of cost segregation studies, though, that is still widely unknown and underutilized, leaving additional (sometimes considerable) tax benefits on the table for property owners and investors. That is the “write-off” portion that is applicable when a property is undergoing renovations.
To best appreciate this idea, it is important to first understand the underlying basis (pun intended) for any depreciation of property. The IRS allows a business owner to deduct any expenses necessary for the running of the business. Any item that is generally consumed immediately, such as office supplies for example, are allowed to be deducted or written off completely, within the year those expenses are incurred. Investment property, however, as per IRS direction, gets “used up” or consumed over 39 years for commercial property and 27.5 years for residential property. That requires the deductions of the money spent on them to be spread out over those periods of time.
These long periods pertain only to the actual structure of the building, together with anything necessary for its essential operating use. Cost segregation gets involved when discussing any items which fall outside of the "base building" category. Generally, decorative, ornamental, task-related or non-essential components inside the building can be depreciated over a five-year or seven-year period, under an accelerated method, and any land improvements that surround the building fall into the 15-year depreciation category, under an accelerated method.
What happens, however, if you get rid of something that was previously classified as belonging to the five-year category, before those five years are up? The same question applies for the 15- and 27.5/39-year buckets. The answer is that you can immediately write those assets off today, assuming you can properly quantify their remaining net value. Being that those items no longer exist, you have, literally and figuratively, ended their life cycles. Your original investment into that item has completed its course.
Hotels, nursing homes and multifamily properties are prime examples, although certainly not the only examples, of properties that are typically renovated—sometimes extensively—upon trading hands. At the very least, substantial upgrades are needed to get the property in line with the investment plans of the new owner. Many hotel chains require, as part of a way to increase per-room rates, immediate substantial renovations on properties that don’t need any work. These renovations create a golden opportunity to not only maximize the benefits of cost segregation for the items originally purchased, as well as the new items installed during the renovation, but also to identify any and all assets that were part of the originally purchased asset and were destroyed during the demolition phase of the renovations at the property. It is these assets that may be written off entirely.
Each kitchen cabinet, yard of carpeting, area of asphalt and parking sign represents money that may be hitting the bottom-line expense by deducting such assets from the basis of the property. All that is needed is a careful, detailed indexing of these items as they are removed.
For example, during a recent study that we performed on a garden-style, multifamily renovation, we were able to identify a full 25% of the original purchase price for immediate write-off. This added millions of dollars to the savings that would already be generated by the standard cost segregation study on the property. These numbers are typical, and can actually be higher depending on the nature of the renovation.
The problem is that, in many cases, the property owner fails to capitalize on this opportunity, allowing the original items to sit on the tax books and continue their course of depreciation, even though they are now considered “ghost assets,” since they are no longer in existence (i.e. “in service”). The old carpeting, for example, may no longer exist in the building, but it still exists on the tax books.
This is often overlooked, for one of two reasons. In some cases, the property owner puts off doing a cost segregation study until the renovations have been completed. Failing to properly catalog and quantify the components of the building before they are torn out makes it impossible to pinpoint accurately what was removed, therefore no longer allowing them to be written off immediately and taken off the tax books. In other cases, the owner may actually have had full cost segregation studies performed on both the original purchase as well as all of the new components added during the renovation, but they did not have the sophistication necessary to complete the write-off component.
Recently the IRS issued new Regulations (TD 9564) on how to treat amounts paid to acquire, produce, or improve tangible property. Included in the new regulations is the “unit of property” concept. These new Regulations reaffirm the concept of a write-off study. Previously, a building was treated as one unit; all renovation work was viewed within its relationship to the entire building. This allowed for the immediate expensing of repairs. Under the “unit of property” concept, a building is broken down into as many as nine structural components, with each component viewed as its own unit. While this severely limits the ability to deduct these expenses in the year incurred, with careful planning, it allows the opportunity for the taxpayer to take retirement losses for assets removed in the renovation.
The only caveat to this is when the renovations are so substantial and immediate that the IRS may consider the original purchase an acquisition of land, allocating the entire purchase price as such, and thus negate any possibility of a write off from the discarded components. This would require a proper valuation of the original purchase to determine what value would be placed on each of the assets at the time of purchase. Every situation is different, and the exact point at which this would apply is for the property owner’s accountant and a cost segregation specialist to advise.
The perfect scenario for a property owner is to get a reputable, proactive cost segregation firm involved immediately, before any demolition of the property begins. By taking it step-by-step, from purchase to demolition to the ultimate renovation, the property owner can most effectively utilize the life cycle of the investment and gain the greatest income tax benefit possible from the allowable deductions.
Eli Loebenberg is CEO of Madison SPECS LLC, an affiliate of Madison Commercial Real Estate Services. He may be contacted here. The views expressed in this article are the author’s own.