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Friday, February 13, 2004
YOUR BUSINESS: Marc Powers
Personal property depreciation can save company a bundle
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Thousands of commercial property owners overpay federal and state income taxes every year because they are depreciating property as "real" property over 39 years when a significant portion of the property could be classified as "personal" property or land improvements. Personal property generally can be depreciated over three to 10 years, and land improvements over 15 years. These changes can dramatically affect the amount of taxes you pay each year because depreciation expense can be deducted from otherwise taxable income. A cost segregation study breaks out hidden personal property components and land improvements embedded in the structural building cost. The study is generally performed by a consulting company that employs construction engineers and tax professionals. The consultant uses engineering knowledge and case law to identify and break out the nonstructural components of the building. Existing tax law is then used to depreciate the property over accelerated tax lives. Substantial case law is available to support these deductions. The case law primarily stems back to cases involving the Investment Tax Credit, which was eliminated in the 1986 Tax Reform Act. In 1997, a tax court held that if the property would have qualified as tangible personal property under the repealed ITC, that same property would also qualify as tangible personal property under current tax depreciation methods. Under new IRS rules, the IRS allows you to make an automatic (no IRS approval needed) change in accounting for depreciation on a retroactive basis. The increased deduction for all previous years can be taken in the current year. This can equal tens of thousands or even hundreds of thousands of dollars in tax savings. Say a local entrepreneur built a plant, warehouse or office building in January 1998 for a total cost of $3.9 million, not including movable equipment. Without a cost segregation study, the accountant is probably depreciating the property over 39 years, producing annual depreciation of $100,000. Using a general rule of thumb in the industry, manufacturing plants generally have 10 percent to 55 percent of hidden personal property or land improvements. Let's assume this plant had 20 percent personal property and no land improvements based on a cost-segregation study done in February 2004. Let's further assume the personal property can be depreciated over five years, which would be very common for many income-producing facilities. With these facts, the accumulated depreciation recorded on the tax books of the company through Dec. 31, 2003, would be about $600,000, which is six years at $100,000 per year. However, the accumulated depreciation that is allowable using the cost segregation study is $1.26 million, producing a staggering difference of $660,000. Let's further assume that the owners are taxed at 40 percent for both federal and state purposes. We just produced an IRS windfall of $264,000. That is free cash flow to the company. You can do whatever you want with it. Being a conservative accountant, may I suggest paying down debt or making further investments in the business? What have we effectively done? The deductions would have come anyway over the next 39 years, which may be more than your remaining life expectancy. You have effectively accelerated tax deductions legally due you that have produced an interest-free loan from the IRS. Common examples of hidden personal property include process-heating and ventilating systems, electrical and plumbing costs that relate directly to the processing-equipment (including computers), flooring and wall coverings, moveable wall partitions. Other improvements generally lumped in with the cost of a building are outdoor lighting, fencing, sidewalks, drainage, parking lots, landscaping, roads, site utilities, specialty structures and signs. Companies or individuals best suited to consider a cost segregation study include all post-1986 construction, including new development; existing buildings undergoing renovation or expansion; office leasehold improvements; and new real estate purchases that were constructed at any time. Industries that generally benefit from these studies include but are not limited to: automobile, truck and equipment dealerships; fast food and large restaurants; financial institutions and their branch offices; manufacturing facilities; apartment complexes; distribution/warehouse centers; hotels/motels; medical centers; nursing homes; office buildings; retail chains; shopping malls; supermarkets; and office buildings. There also are advantages of having cost segregation studies for buildings to be sold and for estate tax purposes. The new tax law also allows for the deduction of up to $100,000 of personal property in any single year. This is just an additional tax incentive to have a study done. Ironically, there can also be a negative impact of not having a cost segregation study done. The IRS regulations require that a taxpayer compute depreciation on what is allowed or allowable. Therefore, it is possible that the IRS could disallow depreciation deductions taken on personal property classified as real property after the personal property life has expired. In addition, it is possible the IRS calculates a bigger gain on a sale of property by reducing the basis in the hidden personal property for depreciation that should have been taken in previous years. There are many technical components to the process from an engineering, appraisal, and tax perspective. Accordingly, I recommend that you hire a firm that specializes in doing and applying these studies. It is not too late to have a study done to reduce your 2003 taxes.
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