Feature
by Douglas Schultz and Alex Yarmolinski
Apartment building owners 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. Residential rental property is generally depreciated for tax purposes using the straight-line method over 27.5 years. Furniture and fixtures are depreciated over five or seven years. Land improvements, such as landscaping and parking lots, are depreciated over fifteen years. Unimproved land is not depreciated at all.
Cost segregation may lead to greater 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.
If one could take a portion of a building that would normally be depreciated over 27.5 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 asset classes with shorter depreciable lives. The result is faster depreciation on a portion of a long-term asset.
Recycling investment tax credit case law from the 1980s
In 1981, when Congress created the Accelerated Cost Recovery System (ACRS), it mandated that a building could not be broken up into real and personal property components. Prior to that, component depreciation generally referred to real property components such as the building shell, lighting, flooring, shelving, etc. Component depreciation, however, was essential for determining the amount of credit that could be claimed for purposes of the investment tax credit (commonly referred to as ITC). Taxpayers fought for component depreciation in Tax Court to claim the benefits of this credit. The investment tax credit was repealed in 1986. Thereafter, entire buildings were typically treated as real property and depreciated using the straight-line method over 27.5 or 39 years under the current Modified Accelerated Cost Recovery System (MACRS).
In recent years, taxpayers have examined court cases dating back to the days of the investment tax credit (ITC) to distinguish items of personal property from items of real property. The theory is that if an asset would have been tangible personal property for purposes of ITC, it should also be personal property for current MACRS cost recovery purposes. The Tax Court adopted this approach in UFM, Inc. and Subsidiaries, TC Memo 1994-239. The court noted that assets held as personal property for ITC purposes also should be personal property for MACRS depreciation purposes. In a more recent case, Hospital Corp of America & Subsidiaries, (1997) 109 TC 21, the Tax Court rejected the IRS’s position that the ITC cases were decided under pre-ACRS law and were not relevant under MACRS. The Tax Court has acquiesced sufficiently to open the door for cost segregation studies to identify components of a building that are not inherently permanent. These studies create detailed inventories of individual assets to distinguish items of personal property from items of real property.
Examples of personal property components
Lighting Equipment
The courts have consistently held that where lighting fixtures are the primary lighting source, they are structural components of a building. However, special lighting that includes lighting to illuminate the exterior of a building but not the illumination of parking areas is tangible personal property. Lighting fixtures have been held to be tangible personal property where the lighting is installed for security, decoration or plant growth. This includes chandeliers and decorative lighting installed for atmosphere rather than lighting.
Exterior Building Ornamentation
False balconies and other exterior ornamentation that have no more than an incidental relationship to the operation or maintenance of a building are generally held to be personal property. A large retail chain won a case where “décor finishes, primarily its decorative canopy system…including the concrete foundation, concrete piers, lumber, and signs attached thereto” were considered to be personal property.
Carpeting and Other Floor Coverings
The IRS has ruled privately that carpeting is personal property “no matter how permanently installed, where it can be removed without requiring resurfacing or restorative work to the floor…” The Tax Court has held that carpeting attached to the floor via a general-purpose latex adhesive is tangible personal property.
Walls and Partitions
Non-permanent, movable partitions, whether ceiling or bank-height, are tangible personal property and not structural components.
Land Improvements
Landscaping, driveways, sidewalks and gardens are not structural components of a building and, therefore, can be treated as personal property with a fifteen-year life.
Cost Segregation Studies
Cost segregation studies can be performed on purchased buildings, newly constructed buildings and tenant leasehold renovations. Studies can be performed for buildings placed in service as far back as the mid-1980s and no amended returns are required. 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 endeavor.
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 can 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. This results in a net present value savings of between 3 and 5 percent of the property’s cost. Next, you will need an accountant 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.
For apartment buildings placed in service after September 10, 2001, there is an added benefit to cost segregation: 30 percent bonus depreciation may be claimed on all personal property with a class life of 20 years or less. That includes everything from special lighting to ornamental fixtures and land improvements. Certain leasehold improvements are also eligible for the 30 percent bonus depreciation, provided the improvements are used exclusively by the taxpayer and are placed into service more than three years after the date the building was first placed in service.
Benefits from cost segregation studies
Pre-Existing Apartment Building for the Taxable Year 2002
A 25-unit apartment building was purchased in 1997 for $4.5 million. Of that, $3 million was allocated to depreciable building improvements with a depreciable period of 27.5 years. The annual depreciation deduction was calculated to be $109,091. Therefore, between the years 1997 and 2001, $545,455 of depreciation expense was taken. A cost segregation study was performed in 2002, 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 $535,458 against 2002’s taxable income. In a 38.6 percent tax bracket, this depreciation adjustment would translate into a possible cash savings of $206,687.
A Newly Constructed Apartment Building for the Taxable Year 2002
A 25-unit apartment building was placed in service on January 1, 2002. The land cost was $1.5 million and the construction cost was $3 million. Without a cost segregation study, the 2002 depreciation expense was $104,545. 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 15-year property, the total depreciation expense would then be $437,682, including 30 percent bonus depreciation. This would be an additional $333,137 depreciation expense in the first year alone. In a 38.6 percent tax bracket, the 2002 cash savings would equal $128,591.
There are two caveats to consider before undertaking a cost segregation study. First, if you or your co-owners are 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. Second, you should check to see whether the additional depreciation deductions might cause you to be subject to the alternative minimum tax (AMT). If you are subject to the AMT, the benefits described could be reduced.
Conclusion
A cost segregation study can be of enormous benefit in increasing cash flow to apartment 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 tax return. In addition, 30 percent bonus depreciation is allowed on personal property and certain leasehold improvements acquired after September 10, 2001.
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. To find out how a cost segregation study can affect the depreciation expense on your building, please call us.
The opinions expressed in this article are those of the authors and do not necessarily reflect the view point of the SFAA or the San Francisco Apartment Magazine. The information within this article is general in nature. Doug Schultz is a CPA and partner in the tax practice at Burr, Pilger and Mayer. Alex Yarmolinsky is a CPA and a manager in the tax practice at Burr, Pilger and Mayer. Both can be contacted at 415-421-5757. Copyright © 2003 San Francisco Apartment Magazine