Guest Post by David Kurtz, CPA: The rules and choices in determining the lives, methods and placed in service dates of certain rental real estate, such as office buildings, shopping malls and centers and warehouses, are complex and need to be carefully considered because supportable larger depreciation expense deductions can effectively (i) defer federal income taxes of 25% on rental real estate income and (ii) convert up to 35% income tax rate savings into 25% income tax cost on the sale of depreciable rental real estate, which is a permanent tax savings of up to 10% of the depreciation expense deductions.
Let’s look at an example. For a taxpayer in the 35% income tax bracket, every $10,000 in rental real estate depreciation expense deductions, $2,500 of income tax is not paid until the property is sold and $1,000 of income tax is never paid.
An engineer’s cost segregation study, rather than a CPA’s study, can provide an owner of rental real estate with the largest depreciation expense deduction each year. It doesn’t matter whether the rental real estate assets are new or used or whether the assets are placed in service during the current and/or prior tax years. A cost segregation specialist should provide you with a preliminary present value of income tax savings as part of their fee proposal for doing a cost segregation study, and will provide you with a cost/benefit analysis of having the study done.
IRS rules allow taxpayers to make calculated depreciation changes for the current tax year and all applicable prior tax years without having to file amended tax returns. It is considered a change in accounting method, so even if you bought the rental real estate years ago, you can get a cost segregation study to determine shorter lives for some of the assets and get a rather large deduction on your current year income tax return.
An additional first-year, or bonus, depreciation deduction can be taken equal to (i) 100% of the cost of qualified leasehold improvements acquired before January 1, 2012 and (ii) 50% of the cost of qualified leasehold improvements acquired after December 31, 2011 and before January 1, 2013. Generally speaking, qualified leasehold improvement property is interior improvements to a building that are made pursuant to a lease to a portion of the building to be occupied exclusively by the lessee. The improvements are placed in service more than three years after the date the building was first placed in service. Examples of qualified leasehold improvements are:
- Electrical or plumbing systems
- Permanently installed lighting fixtures
- Ceilings and doors for a lessee’s space, not a common area
Qualified leasehold improvements do not include enlargement of a building, elevator or escalator, any structural component of a common area and the internal structural framework of the building.
Additional first-year, or bonus, depreciation is different from the expensing of certain depreciable assets, including qualified leasehold improvements, qualified restaurant property, and qualified retail improvement property. Expensing is generally not a good idea for certain partnerships, but bonus depreciation avoids alternative minimum tax and can be a good idea. The rules about the expensing of depreciable assets are even more complex and beyond the scope of this blog.
David Kurtz started Kurtz & Company, P.C. as David M. Kurtz, P.C. in December 1992. His firm specializes in federal and state income tax return preparation, planning and compliance for real estate, oil & gas, entrepreneurial and middle market businesses. They have extensive experience with partnerships, multi-state taxes and foreign investors in U.S. real estate. Their vision is to provide the business world with worry-free income tax return preparation, compliance and planning services that increase cash flow. Follow David’s income tax blog.