Feature

by Lynn Henley

Net cash flows, the differences between the cash generated and the cash used by an investment, represent the return on investment. Depreciation, because of its deductibility, may indirectly have a substantial impact on net cash flows. Although it is neither a source nor a use of cash, the depreciation expense lowers income taxes by reducing taxable income. Lower income taxes result in increased cash flow. This article will explore some of the strategies available for maximizing the substantial benefits of the depreciation expense.

Depreciation: The Basics
Depreciation is a process by which the cost of an asset is allocated over the periods in which the asset is theoretically used. The allocation of the cost is determined according to certain methods and class lives. Residential rental property, for example, must be depreciated using the straight-line method over a 27.5-year life. Under the straight-line method, the depreciable value of the asset is divided equally (subject to the mid-month convention) over the prescribed 27.5 years. Other types of property (other asset classes) are subject to different methods and class lives. Personal property, for example, is subject to the double declining balance method and generally must be depreciated over either seven or five years. The cost of depreciable land improvements must generally be depreciated using the 150 percent declining balance method over fifteen years. The cost of land is not depreciable.

The magnitude of the deduction for depreciation expense in any given year is simply the result of a mathematical calculation. Once the values of the asset classes have been determined, the amount of the deduction in each year is a foregone conclusion. The key to the fastest recovery of an investment through depreciation is to allocate as much value as possible to the depreciable assets and, among the depreciable assets, to allocate as much value as possible to the assets with the shortest lives. Although the allocation of value to the assets with the shortest lives does not change the overall depreciable value of the assets, this strategy does create larger deductions sooner.

Allocating the Purchase Price
When residential real estate changes hands, the land, land improvements and personal property are generally sold together for a single sum. For tax purposes, the sum or purchase price must be allocated between the various asset classes. The asset classes discussed in this article are personal property, land improvements, buildings and land. The method by which this allocation may be made is addressed in Treasury Regulation 1.167(a)-5. Pursuant to these treasury regulations, the total purchase price must be allocated between the various asset classes in the same ratio that the value of each asset class bears to the total value of all the assets purchased.

Personal Property
The asset class “personal property” includes, among many other items, furniture, cabinets, carpeting, electric kitchen equipment, bathroom and kitchen fixtures and movable partitions. Structural components such as plumbing, heating and electrical wiring that are a part of the operation of a building are generally considered to be part of the building rather than personal property. Helpful guidance with regard to the classification of assets as personal property may be found in the body of law that developed around the now-repealed Investment Tax Credit.

Land Improvements
The classification of a land improvement as a depreciable asset requires a thorough understanding of the distinction between improvements that are “directly associated” with buildings versus those that are “inextricably associated” with the land. For example, a road that is useful only as long as the building’s loading dock exists would generally be considered directly associated with the building, whereas a road that leads to the general area of the building would usually be considered inextricably associated with the land. Other examples of land improvements that might be classified as depreciable or non-depreciable, depending upon their most relevant association, include sidewalks, fences, sprinkler systems, landscaping and outside lighting.

Buildings
The concept of value in the real estate context is quite complex. There are a number of acceptable methods by which the depreciable and non-depreciable components of a property may be valued. Although the Internal Revenue Service requires a reasonable valuation based on relevant facts, it has been quite flexible in its acceptance of various approaches. When valuing a building, all of the pertinent information about the building must be incorporated in the valuation process. For example, many people use replacement cost to value a building. Although the replacement cost method may be appropriate in the case of a relatively new building, it may not be an appropriate indicator in the case of an older building. In an old but profitable building, the most favorable allocation might be obtained by capitalizing the anticipated cash flows. A professional appraisal of the various asset classes may also be extremely helpful. Last, the allocation should be adjusted for special valuation issues, including below-market rents and the special issues associated with condominiums.

As key advisors to real estate owners, we have found that careful consideration of the land/building/personal property allocation can improve the return on investment significantly. When you purchase your next property, keep this allocation information in mind. These strategies, working in concert with many others, will help to ensure that your investment brings you many happy returns.

The opinions expressed in this article are those of the author and do not necessarily reßect the viewpoint of the SFAA or the SF Apartment Magazine. Lynn Henley is a Tax Manager with Burr, Pilger & Mayer LLP, a full-service accounting and consulting firm. She is a CPA and has over twelve years experience in tax accounting. Questions regarding depreciation or other tax issues may be directed to Lynn at 415-421-5757. © Copyright 2002.