Now is time to spruce buildings,
before shorter depreciation window closes
Investors usually rank appreciation as a top financial benefit to owning commercial real estate. But for a limited time, depreciation can also reap some economic rewards, especially for owners planning or pursuing renovation of their properties.
A little-known tax provision, which expires at the end of the year, allows owners to write off depreciation on many building improvements over a shorter period: 15 years, rather than the usual — and some owners would say too long — 39 years. During tax season, such sped-up depreciation means property owners pay less in taxes or get a refund check from Uncle Sam.
Either way, they end up with a little extra money in their pockets, which the federal government hopes they’ll pump back into their real estate to spark the industry, as well as the greater economy, say commercial real estate brokers.
The provision encourages owners to spruce up their property providing motivation that some say is rare. A lack of incentive is one reason “why all the buildings in downtown Minneapolis look like cardboad boxes,” says Alan Fine, a senior lecturer in strategic management and organization at the Carlson School of Management at the University of Minnesota.
For building owners, “it promotes faster growth and a quicker return on investment,” says Jim Wagner, property manager with JGM Properties Inc., a commercial management company based in Bloomington.
Small businesses, in particular, will appreciate the boost in cash flow, says Fine: “It’s a great way for them to recover costs sooner.”
Paint jobs qualify
Paint jobs, window treatments, new carpeting, door replacements and other similar run-of-the-mill updates qualify. They must be placed in service before January 1, 2006, the deadline spelled out in the American Jobs Creation Act of 2004, the source of the provision. The regular 39-year depreciation window returns after that date.
“This is a year to be making a move and making improvements on some space that needs to be improved,” says Kay Harris, principal and CEO of St. Louis Park-based KayHarris Real Estate Consultants, a commercial real estate brokerage firm.
The depreciation is straight-lined over the following 15 years, which means 1/15th of the expense is written off each year up through the 15th year. Lessees can claim the deduction if they’ve paid for the renovations themselves.
There are also many exceptions. Only so-called leasehold improvements — those that affect space occupied by legitimate leasing tenants — are eligible. Therefore, owners who occupy 100 percent of their properties cannot take advantage. Off limits are common areas, such as bathrooms, elevators, lobbies and hallways, as well as the entire building exterior.
“You actually have to be pursuing having a business come in” as a tenant, says Wagner. “The whole idea is economic growth — not just for making your building look nice.”
Wagner, who owns an interest in four buildings of the 11 managed by JGM Agency and is a CPA, will be getting some money back as a result of the tax provision.
Since he and his partners purchased the Hudson Road Office Park Building (which is actually three buildings based in Woodbury) in 2005, they have spent $88,600 in improvements. They include various office buildouts, consisting of flooring, acoustical ceiling tile, electrical work, carpeting, painting, drywall installation and taping and installation labor.
Of that amount, $30,119 was used to remodel a hallway — a common area that must be depreciated over 39 years.
The remaining $58,481, however, can be depreciated over the 15-year recovery period. For their 2005 tax returns, Wagner and his co-owners can take that total amount and divide by 15 years. Due to a half-year convention for the first year — the law generally allows owners to claim six months’ worth of the depreciation in the year they put the property into service, regardless of how late in the year they make the purchase — they must take that number and divide by two. $1,949 is divided among Wagner and his co-owners based on each ownership stake, and then that number goes on that person’s tax return.
This 15-year write-off “is over double the regular write-off of 39 years,” says Wagner. Comparing the two, “It’s night and day.”
Extension unlikely
Until Hurricanes Katrina and Rita wreaked havoc on the Gulf Coast this summer, Congress was prepared to extend the tax provision for at least another year, says Wagner. That likely won’t happen now, but any resulting slowdown from the disaster “might impel government to renew it.”
Marty Bakko, a CPA and partner with Virchow Krause & Co., Bloomington, says he believes the squeeze on government resources with the war in Iraq, coupled with the exorbitant tab for hurricane cleanup, sounds a death-knell for any future round of real estate tax breaks, bonuses and other incentives. As deductions go up, owners’ taxable income goes down, pushing down tax revenue for the government, he says.
Adds Adam Mikkelson, a CPA with Virchow Krause: In the South, tax-free zones should boost wide-scale redevelopment and repairs of flood-damaged commercial real estate, “rather than broad tax law changes that apply to everybody.”
Cost studies can help
To help real estate clients figure out their tax picture, CPAs have developed cost segregation studies to determine how their assets can be depreciated for tax purposes. The process usually involves bringing engineers into a company to identify the “class life” of each part of a building, which involves separating real property from personal property.
The traditional 39-year period for depreciating commercial real estate “is a bad deal,” says Alan Delage, a tax-services CPA and shareholder with Froehling Anderson, Minnetonka. “In the tax world it’s ancient history — it’s forever.” The main building structure falls into this category.
But other pieces can be eligible for more rapid depreciation, he says, such as an HVAC system, electrical wiring, or in industrial buildings, air compressor systems and thick concrete floors for supporting heavy machinery.
Many clients assume they throw their entire building into a 39-year asset life, without breaking it down, says Mikkelson, with Virchow Krause. Seven-year assets, for example, would include phone systems, office furniture and artwork; five-year assets would include computer equipment, he says.
The cost segregation process ensures that building owners recover all their costs as soon as allowable for assets that depreciate at different rates.
CPAs and commercial real estate brokers are also trying to get the word out about the recent — if fleeting — changes in tax law. So far, clients are showing interest, but the increase has been gradual because most business owners are focused on other matters.
“The job is much much more important to be making money than to worry about tax law,” says Wagner.
[contact] Marty Bakko, Adam Mikkelson, Virchow Krause & Co.: 952.835.1344; mobakko@virchowkrause.com; amikkelson@virchowkrause.com; www.virchowkrause.com . Alan Delage, Froehling Anderson: 952.979.3100; aland@fapw-cpa.com; www.fapw-cpa.com . Alan Fine, Carlson School of Management, University of Minnesota: 612.624.5523; afine@csom.umn.edu; www.csom.umn.edu. Kay Harris, KayHarris Real Estate Consultants: 952.915.4444;kayharris@mn.rr.com; www.kayharrisre.com. Jim Wagner, JGM Properties Inc.: 952.884.8088; jimw@jgmproperties.com; www.jgmproperties.com.
