A Cost Segregation Study Can Pay for Itself
But will it ruin a Section 1031 exchange?
November 8, 2007
by Michael Hauser, Esq./CPA
As many of you know, your real estate clients can depreciate their buildings over 39 years for commercial property and 27.5 years for residential property. Part of their purchase price must be allocated to land, which is non-depreciable. Further, part of their building’s cost can be allocated to depreciable land improvements with a 15-year life, or to personal property within the building, which has a five- to seven-year life.
Since real estate purchase price allocations must be justifiable in the event of an audit, accountants should collect documentation to substantiate the positions taken, especially if the allocation to land is relatively low or if the allocation to land improvements and personal property is high. A purchase agreement allocation between these elements would not be determinative of the values as the IRS could view such an allocation as being self-serving.
Taxpayers who purchase property can retain a specialized appraisal and/or engineering firm to conduct a “cost segregation” study which, modeled on IRS regulations, would break down the purchase price into as many shorter-life elements as is possible (generally, by separately identifying as much “personal property” elements of a building as is permitted). The cost of the study can pay for itself if the taxpayer gets sufficient benefit from having increased accelerated depreciation. The following is a brief discussion of the different elements of real estate for depreciation purposes, and related issues.
- LandEvidence justifying a minimal land allocation is helpful. However, depending on the situation, it may be difficult to attribute the entrepreneurial value of property to the building. For example, the purchaser of a 10-year-old, fully-rented apartment building with a good reputation has a better argument that any value “premium” should attach to the building rather than the land, as compared to the purchaser of a vacant, newly constructed building in a prime area (where the IRS could argue the building is just worth its replacement cost and any value premium should attach to the land). As an alternative structure, depending on the nature of the transaction and the motivations of the parties, purchasers may be able to purchase the building only and ground-lease the land from the seller. The seller (or a third-party) would retain title to the land, and the purchaser would make monthly land lease payments which, if structured properly, would be tax-deductible. This would provide the seller an income stream roughly akin to a seller’s note, and it would reduce the purchaser’s mortgage payments. If the legalities and economics can be worked out, this is a method to, in effect, make the land “depreciable.”
- Land ImprovementsLand improvements are non-depreciable if they permanently improve the land (e.g. clearing and leveling), but are depreciable over 15 years if they improve the land only while a particular building is present. For example, sidewalks, parking lots, and fences are typically depreciable. Land-preparation costs are depreciable if they only enhance the land for a specific use, such as concrete pads in a mobile home park. To illustrate the concept of whether land improvements are related to a particular building – consider a round office building surrounded by shrubbery around the building’s circumference. Clearly, if the building was torn down, the shrubbery would be ripped out as well, suggesting the shrubbery should be considered a depreciable asset. On the other hand, tall trees along the back edge of a property line would likely be considered a permanent part of the property, unrelated to any buildings currently on the property, and therefore would be non-depreciable. A similar analysis would need to be done for other land improvements such as drainage facilities and bridges.
- Personal PropertyGenerally, structural components of a building must be depreciated over the building’s life. However, if property is movable, if it is not permanently attached to the building, or if it is not inherently destined to remain with the building, then it may be personal property which is depreciable over 5-7 years. Examples of 5-7 year property include: floor coverings, wall partitions, signs, window treatments, appliances/kitchen equipment and back-up generators. Although are generally considered structural components of a building with a 27.5 or 39 year useful life, accelerated depreciation is permitted for plumbing, electrical and heating/cooling units to the extent needed for specialized purposes such as a restaurant’s kitchen (rather than for the whole building). Design and installation costs related to 5-7 year property can also be depreciated over a like period.
For recent construction, the best proof of the cost breakdown comes from construction documents like blueprints, sworn statements, builder draw requests, cost worksheets, and invoices. For older buildings, the task is more challenging. One can try to obtain these original documents, retain an expert to perform a detailed cost-estimate analysis, or ask the appraiser to account for at least the major personal property items. One can also calculate the replacement cost of specifically identified 5-7 year items, although the value would need to be adjusted based on the age of the assets.
- Intangible AllocationGenerally, one cannot allocate any portion of a purchase price to intangible assets like the value of leases or tenant relationships. Still, in appropriate settings, one could reduce a purchase price by a small amount and execute a side contract for that five percent wherein the buyer acquires intangibles which can be clearly separated from the property, such as: a covenant not to compete (by building or operating a nearby building), use of the building’s trade name (e.g. the “Gemini Center”), workforce-in-place (preventing the seller from re-locating the building’s employees), information base (tenant payment histories and computer records) and future tenant waiting lists. Such intangibles arguably may be depreciable over 15 years. For a discussion of goodwill and going concern value in real estate purchases, see the author’s article, "The Tax Treatment of Intangibles in Acquisitions of Residential Rental Real Estate" (Wayne Law Review, 2004).
- Section 1031 Exchanges and Other Collateral IssuesSection 1031 tax-free exchanges must involve like-kind property – thus, real estate can only be exchanged for other real estate, and personal property can only be exchanged for similar personal property. The question is – if a significant percentage of a building is considered personal property for depreciation purposes as a result of a cost segregation study, is the taxpayer precluded from exchanging that percentage of the building tax-free in a Section 1031 exchange for new real estate? Although there is no authoritative source directly on point, it appears the answer is that the cost segregation approach will not interfere with a Section 1031 real estate exchange. In a 2006 ruling, ILM 200648026, the IRS held that property identified as personal property for depreciation purposes based on a cost segregation study will nevertheless be considered real estate for purposes of the § 263A interest capitalization rules. Although Section 1031 is not mentioned, the ruling illustrates that the same property can be considered real estate for one tax purpose and personal property for another. With this reasoning, the general test of § 1031 would apply — namely, if the property is considered real property under the local law of the state where the property is located, it will generally be considered like-kind to other real estate. See PLR 9232030. Still, there is uncertainty.Another issue related to a purchase price allocation involves the concerns of the seller. Sellers may want the purchase agreement to recite a high value to the land, since gain on the land may be taxable at 15 percent, while “recapture-type” gain from a depreciable building would be taxable at rates of 25 percent to 35 percent. This situation would generally only arise if the seller does not have much overall gain, and thus may not need to recover all depreciation previously taken. The parties could resolve the issue by just agreeing to have the purchase agreement silent on allocations.Since cost segregation studies tend to favor an allocation to personal property, there might be local property tax effects if there is a different tax rate or different assessment procedure for personal property tax and real property tax.
Finally, although cost segregation can lead to accelerated deductions, there may be a payback in the form of higher tax upon a sale. This is because gain on the sale of property which had accelerated depreciation must be recaptured at ordinary income rates (35%) to the extent of the depreciation taken, while gain from the sale of property which had straight-line depreciation would only be subject to the 25 percent rate of un-recaptured Section 1250 gain.
You can add a great deal of value to your real estate tax advice by letting clients know about the availability of cost segregation studies. However, the cost of the study may be prohibitive depending on the circumstances. Make sure your clients are aware of potential drawbacks and collateral concerns. In any event, an allocation will be necessary, so you should try to collect as much back-up documentation as possible.
© Michael Hauser.
Michael Hauser is a tax attorney with Maddin, Hauser, Wartell, Roth and Heller, P.C. in Southfield, Michigan, where he specializes in tax planning for owners of small businesses. Hauser is also an adjunct professor in the Tax LLM program at Cooley Law School, where he teaches taxation of real estate.