The more depreciation you take, the less you pay in taxes, and the more money you have in hand.
If you were building a new office for your practice, would you have the carpeting tacked in place or glued to the floor? This may seem a matter best left to your builder or decorator, but you might actually want to consult your accountant. Believe it or not, the difference could save you as much as 21 cents in taxes on every dollar you pay for that carpeting.
Since the tax law changes of 2001, owners of commercial property have been able to accelerate the rate at which they deduct from their taxes the depreciating value of certain building components. In other words, they may deduct the depreciation for personal property in an earlier tax year.
This is good news for commercial building owners: The more depreciation you take, the less you pay in taxes, and the more money you have in hand. There's a catch, however: only personal property, not real property, is eligible for the accelerated depreciation.
Personal property, in this sense, means items or assets that are used for a specific business; real property refers to elements of the building that are considered an integral part of the commercial structure. You can't take advantage of the new rules unless you know how to make the distinction, a process known as cost segregation.
These rules may seem arcane, even silly, but understanding them - or hiring someone who does -- can save you thousands if you own your commercial property or are thinking of buying. The depreciation for the building itself is 39 years; other assets can be depreciated over a shorter period. For example, the law allows depreciation over 15 years for improvements such as landscaping, trees, and parking lots; seven years for some types of flooring and millwork; and five years for business-related equipment.
Save tax dollars
Your accountant can give you some guidance on the rules and regulations for determining whether your building's assets fall into the five-, seven-, 15-, or 39-year depreciation category. But you probably should not stop with that information alone, because most likely he'll be working with general information and won't go out and view the actual building.
That's why I recommend most property owners consult a firm that specializes in conducting cost segregation studies (CSS), which identify specific assets that can be classified as tangible personal property for tax purposes, rather than being lumped together as part of the commercial structure.
Mark Rohde and Bill Champion of EMG, a Baltimore-area firm that provides real estate due diligence services, including detailed cost segregation studies, told me that a CSS can provide property owners with verifiable, objective evidence in case a question about accelerated depreciation ever arises. That's information you can take to an audit, should it come to that.
"We physically go on site and assess the property; we look at the actual lighting system, and the actual landscaping. These are elements that [an accountant] won't get looking through a file on the desk," says Champion. "That's not disparaging the accounting firm. However, we believe that you'll get a real benefit to a CSS if you take a two-fold approach, with your accounting firm and an experienced due diligence firm combining to provide maximum benefit under the tax rules."
One place a due diligence firm can help is with the construction of a new building. That carpeting I mentioned? If it is glued down, the IRS considers it a permanent part of the building, and it has to be depreciated over 39 years. If you tack it down, however, it is considered removable, and can be depreciated over just seven years. "It's intricate items like that that can save a building owner a substantial amount of money over the years," Champion says.
But even with existing buildings, he says, "where we're really able to help is in cases where there are issues that require engineering judgment. For example, suppose you have an electrical distribution system in which half of the power supports an X-ray machine and the other half supports the building lights. It will take a highly skilled architect or engineer to determine which portion of that system is supporting each component -- but you may be able to depreciate 50 percent of the lighting faster."
Worth the cost
The fee for a CSS depends on several factors, including the size of the building, but is in the $10,000 range. That may seem like a lot, but in most cases a CSS pays for itself many times over, says Rohde. "We estimate that employing a firm like ours can bring an additional 5 percent in tax relief based on depreciation levels. If you have a $5 million property, that's accelerated tax relief of $250,000."
Once you have a cost segregation study, it's easy to adjust it for changes in the property like remodeling or equipment failure. "If a water heater goes out during the course of a year, our detailed reports allow either us or the accounting firm to go in and look at line 35, cross off that water heater, and fully depreciate it," Champion explains. The company will do an annual update if requested.
Occasionally, owners will want to slow the rate of depreciation -- especially those who will have to pay the dreaded Alternative Minimum Tax, which could render big deductions moot. Such owners might be better served spreading their deductions out over several years. So in the case of that water heater, it might be wise to depreciate it over seven years, rather than the five that is allowed by law.
Champion says a CSS can be helpful to a building owner 99 percent of the time. Still, he says, "It may not be beneficial to have a study if you've already done some prior accelerated depreciation or if you're in a tax bracket that no matter what you do you're going to owe taxes. We will not do a study until we understand your current tax situation, checked whether or not you have accelerated any depreciation, and what your expected use of the building is."
CSS benefits buyers
The tax legislation also offers an advantage to property buyers; they, too, should strongly consider having a CSS performed on the property they've purchased, because they are not bound by the previous owner's cost segregation.
And depreciation is retroactive; someone who bought a building in 2000, for example, can claim depreciation all the way back to 1986.
A CSS can also help an owner determine the right time to sell a property, says Rohde. "Many times companies will own a building for 15 years, and at that point they have lost all of the 15-year items, all of the seven-year items, and all of the five-year items. Cost segregation studies encourage you to actively manage your real estate, including the timing of renovations and the timing of disposition of that particular asset."
Rohde says that whatever a building owner's business is, there are opportunities to save money. The relationship his business has with your accountant or lawyer, he explains, is analogous to that between a primary care physician and specialists.
"To have a good relationship with their patients, doctors need a network of referral people behind them," he says. "We provide one of those network links to the accountant and to the property owners that helps them get a full view and a full assessment of how they can maximize what they're trying to do from a real estate perspective."
This article originally appeared in the September 2004 issue of Physicians Practice.