Tax Savings Through Accelerated Depreciation on the Western Slope

By Robert Drury, CPA

With the current economic climate of a declining stock market and low interest rates many investors on the Western Slope have turned to commercial real estate for future appreciation and diversification. Other companies are relocating to the Western Slope for the quality of life and are investing in commercial property. Favorable interest rates have spurred expansions and new construction.

As with any investment you should look to maximize your return from all possible means. First you should determine the location that is best suited for you. If your location can be flexible, you should look at enterprise zones. Colorado allows tax credits for buying or leasing in enterprise zones that make it attractive to consider. There are numerous enterprise zones on the western slope. Secondly, once you purchase or build commercial property you should get as many tax advantages as possible.

Just as "a dollar today is worth more than a dollar tomorrow," a federal tax deduction claimed today is worth more than one claimed in the future. Applying this cliche to the real world of construction, assume that the deduction is for depreciation and that "today" is a 5 or 7-year recovery period while "tomorrow" is a 39-year recovery period. The accelerated depreciation from the shorter period means increased current cash flow. And what makes this switch even more attractive is that the IRS allows real estate owners to change their method of accounting in order to re-compute the allowable depreciation and claim a retroactive adjustment for previously filed tax returns for both open and closed tax years. This creates an opportunity to correctly classify fixed assets and claim the entire difference between the allowable depreciation and the depreciation actually taken on past tax returns. Through four equal annual adjustments, real estate owners can correct what may have been years of under-utilized property depreciation deductions and realize large tax savings.

What is Construction Cost Segregation?

Properly segregating the costs of a construction project on the Western Slope, or in Colorado generally, is part art, part science. Almost anyone can properly identify and depreciate the costs of manufacturing equipment, office furniture and fixtures, and computer equipment over 5 or 7 years for federal tax purposes. However, construction related costs, which may account for 80 to 90 percent of overall project costs, are generally lumped together as real property having a depreciable life of 39 years. With this in mind, the primary goal of a cost segregation study of a newly constructed, expanded or acquired facility is to identify all construction related costs that qualify for shorter federal tax lives. The result of reducing tax lives from 39 years of straight-line depreciation to 5, 7 or 15 years of accelerated depreciation could have a significant impact on a company's federal tax liability.

What Construction Costs Qualify?

There are two types of construction related costs that qualify for shorter lives: Land Improvements and Personal Property. Land improvement costs qualify for a 15-year depreciable life. Examples include paving, sidewalks, fencing, site utilities, site electrical and landscaping.

Personal property items generally qualify for either a 5 or 7-year life depending on the nature of the business. These costs are not easily defined as they may be related to the equipment or operations housed within the facility or they may be items that are decorative in nature. Personal property examples include process equipment support foundations and framing, process related electrical components, process related plumbing and HVAC, and in some cases, certain process related to land improvement costs. Additionally, allocating the various project soft costs - such as architectural services, materials testing services and construction period interest to the hard construction costs on a functional basis, ensures that a portion of these soft costs are depreciated as short-lived property.

A Word of Caution

Although it pays to be aggressive, it also pays to be defensible. Any position taken by a taxpayer regarding the classification of construction costs as short-lived personal or land improvement property should be able to withstand IRS scrutiny. An abundance of case law deals with what does and what does not qualify as short-lived property. Be cautious when exploiting gray areas, maintain good project cost documentation and consult with a tax advisor that has expertise with cost segregation.

Who Benefits

Cost segregation offers important benefits to those building new, or acquiring and expanding existing commercial facilities, especially given the favorable conditions on the Western Slope. It can also help construction companies in their bidding process to offer additional advice to make owners aware of the benefits of cost segregation; and be able to separately state on their invoices, those items with shorter lives.

Robert Drury is a tax partner at the Grand Junction office of Gordon, Hughes & Banks, LLP. He can be reached at (970) 245-5181, or (877) 882-9853 toll free. This article appeared in the November 6 issue of the Colorado Real Estate Journal.