Although falling cap rates and thinning returns can try today’s real estate owner, recent changes in the tax code nevertheless provide new and creative ways for commercial and multifamily residential properties to maintain or even improve their bottom lines. The most important such change is the IRS’s recognition of cost segregation, a modern form of the modified accelerated cost recovery system, as a legitimate method of depreciation.
Extremely popular through the early 1980s, especially among developers looking for special tax treatment of personal property, cost segregation all but disappeared under the Tax Reform Act of 1986. Yet through a series of cases brought by the Hospital Corp. of America and several other companies, pre-1981 definitions of personal property have now been reestablished–much to the benefit of developers and property owners.
Cost segregation is the practice of identifying, separating and pricing non-structural improvements, including exterior-site amenities, and then maximizing tax write-offs by reclassifying those items as personal property or land improvements, both of which have depreciation schedules steeper than those for real property. For example, apartment owners might separate and depreciate as personal property or land improvements items such as tennis courts, swimming pools, carpeting, wall coverings and even some walls. Likewise, office-building owners might separate out suspended ceiling tiles and hardware, unique tenant improvements and supplemental air conditioning systems. In all cases, much of a building’s costs–sometimes as much as 50%–can, often, qualify for the five-, seven-, or 15-year depreciation schedules of personal property and land improvements, instead of the longer, tax-heavy 27.5- and 39-year schedules they’d otherwise be subject to. The result is a major windfall for owners of all commercial and multi-housing properties.
The IRS has made clear, however, that any owner who segregates costs must first undertake a professional cost-segregation study that both (a) relies on either actual costs or industry-accepted standard costs established by the IRS, and (b) bases its reasoning on engineering or architectural considerations. It cannot be based on owner estimates, unless, of course, the owner can back those estimates up with actual proof.
Considering the last requirement, the best time to consult a valuation expert is before constructing or renovating a building, when engineers and architects can consider design features that may maximize depreciation benefits and tracking costs for individual elements is easier. Yet owners of existing assets can also benefit, as qualified experts typically have engineering or construction backgrounds and can usually find qualified, tax-saving segregations. One such example is that of a fairly new apartment building in Southern California , analyzed by Ralph Consola of Marshal Stevens, a firm that specializes in valuations and cost segregation work.
Using the IRS’s traditional straight-line method, the owner of this apartment building had a $15.8 million tax basis and was entitled to a deduction of $287,698 in the first year of operations. By segregating the property between land, improvements, personal property and land improvement, however, Consola indicated to the owner, how allowable depreciation could be more than $764,207 in the first year and could result in potential savings of almost $2.3 million in income taxes over the first six years of ownership.
Of course, if the owner decides to hold onto the property for more than six years, the tax savings will be lessened as the shorter depreciation schedules expire. Indeed, by waiting for the 27.5 years it will take for the longest schedule to expire, the present value of the savings would, discounting at 10%, be only about $617,000. But this only points to the importance of reassessing disposition schedules.
It also points to one feature of the new rules: they allow the owner who switches over to cost segregation to concentrate benefits more closely in time than did the rules before 1986. Previously, owners had to spread out first-year depreciation over four years. Since 2002, though, taxpayers can take the entire benefit in year one, making it unnecessary to amend prior years’ taxes.
Also, as part of the 2003 economic stimulus bill, the federal government gave taxpayers another bonus: any personal property that qualifies for a 20-year or shorter depreciation life can now have 50 to 100% of its total value deducted in a single year. This means that an office building owner who renovates space for a new tenant, installing customized kitchens or specialized air conditioning, can write off 50 to 100% of the value of those improvements in year one, as opposed to using the 37-year cycle or amortizing the improvements over the life of the lease.
Property owners with at least $1 million of equity in an asset can benefit greatly from having a cost-segregation study performed by a qualified professional, and the potential benefits and applicability to the owners situation confirmed by an accounting professional. And reduced tax bills are just the start. The cornerstone of any property’s value is the income it generates. By improving the cash flow after taxes, the net return to the owner is vastly increased, as is the potential resale value of the property. Additionally, understanding of this process can be passed on to new buyers, who can then implement the program themselves.
Not only does maximizing return on investment require an understanding of these depreciation benefits, but anything less than understanding also amounts to unnecessarily leaving your pockets open to Uncle Sam.
HOOMAN GHAFFARI is a vice president at Grubb & Ellis Co. He specializes in the representation of investment property owners throughout Los Angeles .