Building Cost Recovery Projects

By Ronald J. Kaley, MBA

From a tax planning stance, it is critical for commercial property buyers to ensure they are taking all the current depreciation expense allowable and are taking advantage of the few remaining opportunities for accelerated depreciation. Commercial buildings and their structural elements are depreciated on a straight-line basis over 39 years. However, a building’s basis may be sliced into various components for the best tax results.

Commercial property often contains elements which are not structural components and can be separately depreciated over a shorter recovery period if the actual component costs are known. The depreciation component method is also allowable for used property provided there is proper component cost allocation and the proper assignment of useful lives. To isolate the non-structural portion of commercial property, an examination of contractor invoices must be completed to analyze costs that can be separated. For used commercial property, a purchase price allocation at the time of acquisition, based on the ratio of depreciable improvements value to the property’s entire value, must be calculated.

The Tax Court has often ruled that when allocating the purchase price between land and building, the tax assessor's valuation or a mortgage appraisal may be used. However, IRS states a taxpayer cannot allocate the cost basis in land and buildings solely according to the property tax assessed values when better evidence, such as an engineering report, exists to establish fair market value.

In general, personal property (equipment) with no class life is depreciated over 7 years using an accelerated depreciation method. However, another recovery period may apply if the asset is categorized as a special class. As an example, equipment used by a wholesaler or retailer may fit into a special category called, “Distributive Trade or Services”. In this category, equipment may be depreciated over five rather than seven years. There are many other categories to consider, including groupings for assets used in the manufacture of certain items. In examining contractor invoices, the objective is to associate as much as possible, the construction costs with the business equipment. This can be done by using court decisions and Internal Revenue Rulings as a guide.

In addition, a significant portion of a property's acquisition or construction cost may be allocable to land-related improvements such as landscaping, shrubbery, sidewalks, roads within the property, and fences. Such land improvements, if not explicitly included in another class, and not certain public utility land improvements, may be depreciated over 15 years using an accelerated depreciation method. However, IRS will only allow a taxpayer to depreciate that part of the landscaping immediately adjacent to buildings. The reasoning is only this portion would be destroyed if the buildings themselves were destroyed or replaced. The balance of the landscaping is capitalized and added to the basis of the land. Presumably, driveways, parking lots, artificial lakes, retaining walls, berms, and embankments, also qualify as land improvements.

Carving out components of real property seems logical and in many cases straight forward. However, with numerous court cases and Internal Revenue Rulings, (i.e. the most recent case decided by the courts, Hospital Corporation of America), depreciable property lives may be directly affected by the business conducted. If you are considering purchasing or building, or have recently bought or built a new piece of commercial property, it is advisable to consult your tax advisor to ensure you are maximizing your cost recovery deductions.

Ronald J. Kaley, MBA is a Tax Manager with Echelbarger, Himebaugh, Tamm & Co., P.C. (EHTC). Ron specializes in Cost Segregation Studies and tax planning. He may be reached at 616.575.3482 or ronk@ehtc.com.