Welcome to the first installment in our series of articles exploring tax savings strategies in commercial real estate. In this series, we will delve into various aspects of tax planning and optimization, focusing on how businesses can leverage tax laws to maximize their financial benefits. In this inaugural article, we'll unravel the complexities of depreciation for commercial property and how it can significantly impact tax liabilities. Understanding depreciation and related tax incentives is essential for any business looking to optimize its tax strategy and enhance its bottom line in the realm of commercial real estate. Let's dive in.
Depreciation may seem like a complex accounting term, but its essence is straightforward and holds significant implications, particularly in commercial real estate. At its core, depreciation refers to the recognizing the gradual decrease of an asset over time. An asset, in this context, refers to any resource with economic value that a business owns or controls, such as buildings, equipment, or vehicles. Think of it this way—assets are things you own, liabilities are things you owe and your equity is what’s left. This means that while buildings and equipment may lose value over time, land generally retains its value and is not subject to depreciation.
However, it's important to distinguish accounting depreciation from value depreciation, which occurs when assets lose value due to factors like wear and tear, obsolescence, or changes in market demand. For example, when you drive a new car off the lot, its value typically decreases immediately due to factors like mileage and wear, which is value depreciation. On the other hand, accounting depreciation is a systematic allocation of the cost of an asset over its useful life for the purpose of accurately reflecting its diminished value in financial statements. It's crucial to note that land, unlike other assets, is not depreciable.
Depreciation aligns with the matching principle, a foundational concept in accounting. This principle dictates that expenses should be recognized in the same period as the revenue they help generate. For commercial properties, which generate income over many years, depreciation allows businesses to spread out the cost of the building over its useful life, matching the expense with the revenue it generates annually—most likely rents received. The useful life of a commercial property refers to how long it is expected to remain in service and generate income. The default useful life for commercial real estate, according to the IRS, is 39 years. Based on the type of asset the useful life can vary based on factors such as wear and tear, technological advancements, and market demand. It's important to note that for tax purposes as well, land is not depreciable. This means that when calculating depreciation deductions, only the building and other tangible assets can be depreciated, while the value of the land remains unchanged.
I pointed out the depreciable life for tax purposes. So yes, depreciation isn't solely about bookkeeping; it also influences tax calculations. Tax regulations frequently permit faster depreciation write-offs compared to those used for bookkeeping purposes. This is where the Modified Accelerated Cost Recovery System (MACRS) comes into play. MACRS, provided by the IRS, is a method for calculating depreciation deductions for tax purposes. It assigns specific recovery periods to different types of assets, including commercial property, enabling accelerated depreciation.
There are two popular types of accelerated depreciation under the tax law: Bonus depreciation and Section 179. Bonus depreciation allows businesses to deduct a larger portion of the cost of qualifying assets in the year they are placed in service. This provision furnishes businesses with an immediate tax benefit and serves to stimulate investment. Similarly, Section 179 allows businesses to deduct the full purchase price of qualifying equipment and software purchased or financed during the tax year. This deduction is limited to a specific dollar amount each year and is subject to certain limitations, but it offers significant upfront tax savings for businesses.
However, there exists another potent tool that can additionally hasten depreciation: cost segregation studies. These studies entail identifying and reclassifying components of a building for tax purposes to expedite depreciation deductions.
Here is a scenario: You purchase an office building for $1,000,000 on January 1, 2024. Remember you don’t depreciate land, so you determine the land comprises $100,000, and the building comprises $900,000. If you depreciate the building over 39 years, your depreciation write-off (expense) would be $23,076.92 per year ($900,000/39). Assuming a 37% federal income tax rate, that would save you roughly $8,500 in taxes.
Now, let’s say you decide to get a cost segregation study. After completion, the study Identifies the following costs:
· $100,000 of interior fixtures that can be depreciated over five years
· $100,000 of interior fixtures that can be depreciated over seven years
· $200,000 of land improvements that can be depreciated over 15 years
So now based on the study, $400,000 of the $900,000 building is eligible for bonus depreciation, meaning 100% of that cost could be written off in 2024. Assuming a 37% tax rate, that would result in tax savings of $144,205.13 over depreciating the building with no cost segregation (($412,820.51 – $23,076.92) x 37%). So, you may be wondering how I got $412,820.51—why isn’t it just $400,000. Well, don’t forget we still have the other $500,000 that is depreciated over 39 years--$500,000/39 = $12,820.51. $400,000 + $12,820.51 = $412,820.51.
However, even if you decided not to take advantage of bonus depreciation, those items can be depreciated over a shorter recovery period using an accelerated depreciation method. As a result, your estimated first-year depreciation write-off would be:
· Building ($500,000 / 39 years): $12,820.51 (as mentioned previously)
· 5-year property ($100,000 / 5 years): $20,000.00
· 7-year property ($100,000 / 7 years): $14,285.71
· 15-year property ($200,000 / 15 years): $13,333.33
Total depreciation expense for Year 1: $60,439.55
So even if you opted out taking bonus depreciation, your first-year depreciation write-off (expense) would result in a tax savings of $13,824.17 over depreciating the building over 39 years without a cost segregation study (($60,439.55 – $23,076.92) x 37%).
In summary, depreciation for commercial property is a critical accounting concept enabling businesses to match expenses with revenue over the asset's useful life. Tax depreciation often allows for faster write-offs than book depreciation. Cost segregation studies provide a means to further accelerate depreciation by reclassifying certain building components, offering businesses additional tax benefits. Understanding these concepts empowers businesses to optimize their tax strategy and enhance financial performance.
Next time, we will explore strategies to minimize taxes when dealing with capital gains in commercial real estate transactions. Stay tuned for more insights and tips on maximizing tax benefits in commercial real estate.
Disclaimer: The information provided in this article is for educational purposes only and should not be construed as tax or financial advice. Readers are encouraged to consult with their professionals regarding their specific tax and financial circumstances.
Chris Etterlee, CPA is the managing shareholder of Fuller, Frost & Associates, CPAs. He is an adjust instructor in the Hull College of Business at Augusta University and the business school of Aiken Technical College. He is also the founding member of CTA Works, LLC which specializes in reporting beneficial ownership information under the Corporate Transparency Act.