So you just purchased an office building, ripped out half of the interior walls and interior built-out and remodeled with a nice new layout and design. The collected invoices and construction budget finds its way to your CPA’s office and they tell you to get a cost segregation to accelerate your deprecation. So now what?
The suggested analysis segregates your building into 5-, 7-, 15-, and 39-year property. With the cost segregation you can accelerate the annual depreciation for the building from a 39-year lump sum approach to a faster depreciation.
Very often I get excited calls from newly minted property owners, describing to what length they went to improve their property. Moving walls, new tile floors, fresh paint, new windows and doors, completely new HVAC system, etc. This is the point when I politely interrupt the client right away to start a little educational session. All the items described above are not eligible to be classified as 5- or 7-year property. All these elements become 39-year property after finalization of the project.
The IRS describes in detail (and on hundreds of pages tax code) which items can be used for accelerated depreciation. For the purpose of this blog, I’ll keep it short and in layman’s terms and provide some examples:
Not eligible because it is permanently attached to real estate (39-year property). If it were removed from the building, it would be damaged and thus it does not fall under the 5-year property. One of the tests of eligibility which the IRS uses is the method of attachment.
Floating click floor, vinyl plank, wood floor, carpet, etc.
Eligible for 5-year property
Baseboard, crown molding, chair rails (millwork in general)
Eligible for 5-year property
Considered 39-year property, in most cases
Drywall, textured finishes, paint:
Considered 39-year property
If there is a primary and secondary light source in the building, the secondary light source can be used for 5-year property. For example, if a building has commercial type fluorescent lights and decorative type light fixtures in the client lobby and reception area, the latter would be eligible for 5-year depreciation, while the former, i.e. the primary light source, wouldn’t be eligible.
The list goes on and on, and if the reader is interested to learn more ,we recommend studying the IRS Cost Segregation Guide or contacting our firm for more information.
7-year property is a separate consideration and is distinguished from 5-year property by its use, e.g. a table used on the retail floor (5-year) versus the same table used in a the store manager’s office (7-year). For the purpose of this blog the distinction between 5- and 7-year property is not important.
To stay with the “small office building example”, 15-year property could be the following, among others:
- Paving and parking lot improvements
- Landscape and irrigation
- Fences and walls
- Storm water management
So, let’s put all this together:
Alterations to the building components and mechanics itself do not fall under 5- or 7-year property classification. Moving walls, painting, tiling, changing out the HVAC system, adding sprinklers, etc. will not contribute to accelerated depreciation under a cost segregation scenario. Can you offset the cost in a different way in your tax returns? Sure, but this is a question for your CPA and will not be discussed here.
Take a look at the IRS link https://www.irs.gov/businesses/cost-segregation-atg-chapter-6-4-relevant-court-cases#4 to get a quick overview of case law separating §§1245 (tangible property) and §§1250 (real property).
If you have very limited built-out like carpet, plank flooring, baseboard, cabinets, secondary light sources, sinks, etc. and your building is not larger than 4,000 to 5,000 SF, a cost segregation might not be beneficial enough to justify the expense.
On top of that, if your standalone building is a zero-lot-line property with very limited parking space or even on-street parking, the amount of the 15-year property will be very low as well.
In a lot of cases, when we find basic interior built-out and limited 5- and 7-year property, the 15-year site improvements most often “save the day” by contributing to a healthy 15-year segregated portion of the entire project. But if the building sits on a zero-lot-line property, this advantage goes away. In these cases, the tax payer is ill advised to get a cost segregation.
However, size does matter. If the building is above 5,000 SF, even basic 5-year build-out will accumulate to an amount which will help to accelerate the deprecation.
As always, thanks for reading our blog. Call or email with questions anytime.
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