When purchasing real property such as office buildings, apartment buildings, factories, shopping centers, and restaurants, taxpayers often fail to allocate the purchase price in a way that maximizes depreciation deductions. The purchase price can be allocated to land, land improvements, buildings, and personal property.
There are different depreciation rules for each of these classifications: often fail to allocate the purchase price in a way that maximizes depreciation deductions. The purchase price can be allocated to land, land improvements, buildings, and personal property.
There are different depreciation rules for each of these classifications:
- Land is not depreciable
- Land improvements are depreciated over 15 years using 150% declining balance (accelerated depreciation)
- Nonresidential buildings are depreciated over 39 years using straight-line depreciation
- Residential rental buildings are depreciated over 27.5 years using straight-line depreciation
- Equipment tends to be depreciated between 3 to 7 years using 200% declining balance (really accelerated depreciation)
A three step process can help taxpayers allocate as much of the purchase price to classifications that are depreciated most quickly:
- Make an initial land to building cost allocation
- Separate land improvements from overall land costs
- Use a cost segregation analysis to separate personal property costs from building costs
Make an Initial Land to Building Cost Allocation
The allocation should be based on relative market values of the land and the building. This allocation may be agreed upon by the buyer and seller and included in the sales contract. The allocation may also be based on a qualified appraisal. As much as possible, costs should be allocated to the building since land is not depreciable. However, it is preferable if costs can be allocated to land improvements rather than to the building because land improvements are depreciated more quickly than building costs.
Identifying Land Improvements
Land improvements include such assets as sidewalks, roads, drainage facilities, bridges, fences, landscaping and shrubbery. Only landscaping that is adjacent to the building is depreciable. Landscaping around the perimeter of the land tract is treated as a pure land cost and is not eligible for depreciation.
Use a Cost Segregation Study to Allocate Costs from the Building to Equipment
Equipment is depreciated much more rapidly than building costs. A closer examination of building costs often shows that part of the building cost actually relates to equipment, which is eligible for faster depreciation deductions over a shorter period of time. A cost segregation study is the process of reviewing the costs incurred to identify the specific types of assets being placed into service. For example, electrical and plumbing systems are typically depreciated over the building’s depreciable life. However, a cost segregation study may reveal that specialized plumbing and electrical systems are related to equipment and should be depreciated over the equipment’s shorter life. An example would be a hospital whose equipment requires specialized electrical wiring.
Example: ABC Corp buys a commercial building for $1 million. It does a rough cost allocation and allocates $200,000 to land and $800,000 to the building. The $200,000 land cost is not depreciable. The $800,000 building cost is depreciated straight line over 39 years at $20,512.
Total first year depreciation: $20,512
Example 2: Same facts as above except that ABC Corp does a more thorough allocation. It determines that $60,000 of the $200,000 land costs are actually land improvements. After a cost segregation study is done, it finds that specialized electrical and plumbing work costing $50,000 should be depreciated as equipment.
The depreciation for each classification is as follows:
- Land of $140,000 is not depreciable
- Land improvements of $60,000 are depreciated over 15 years using 150% declining balance method
- Specialized wiring and electrical costs of $50,000 are depreciated over 7 years using 200% declining balance method
- Building costs of $750,000 are depreciated straight line over 39 years
Total first year depreciation:
- Land Improvements $8,000
- Equipment $14,250
- Building $19,230
- Total $41,480
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Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.