I think most real estate investors understand how depreciation creates a significant tax advantage. Depreciation is the means that allows an investor to have a positive cash flow while claiming tax losses. I think we can all agree that spending a lot of cash to create tax losses is a less than desirable way of saving money on your tax return.
I suspect though that many investors have no idea just how much depreciation can be taken in the early years of a property’s life. Spreading depreciation out over 27.5 years does help the bottom line, but if it was possible to spread a lot of that depreciation over a 5 year period I think you can see how that might prove to be a far better tax benefit.
Recently I talked about land improvements which are depreciable though land clearly is not. I gave you a taste of what can be carved out as a 15 year land improvement. Clearly, depreciating an asset over 15 years is better than 27.5 years. If you didn’t read the post you might want to take some time to read it.
I suspect though that many investors might be surprised at what can be classified as 5 year property. Revenue Procedure 87-56 is what is commonly used to classify assets and determine their tax life. Common 5 year property listed in tax returns I see would include appliances, blinds, drapes and perhaps carpeting. As an investor it may not seem worthwhile to take much effort to break these items out and I would agree.
There is much more than can be classified as 5 year property. Some key areas include special purpose plumbing and special purpose electrical. There is important case law that set precedents allowing these items to be treated as 5 year property.
A very important tax case, Hospital Corp of America v. Commissioner in 1997 clarified an earlier ruling that stated electrical wiring, plumbing and such connected to personal property was not part of the electrical or plumbing system but was part of the personal asset. This is a huge tax distinction.
In other words the wiring that connects a range to a circuit breaker is 5 year property not 27.5 year property.
Exterior site lighting and the electrical wiring necessary to make them work is also 5 year property. It is Reg Section 1.1245-3(b) that defines this lighting as tangible personal property.
Decorative lighting is also tangible personal property. Metro National Corp v. Commissioner is the case used to support this classification.
These are a few of the cases and regulations used in breaking out a substantial amount of 5 year property. In order to do this properly though a cost segregation study needs to be done. Often cost segregation studies can be quite costly — but they don’t have to be.
Reading through this list should give you a much greater appreciation for just how much more depreciation can be take in the first 5 years of a property’s life. There is more, but this is much more than I think most of you realized.
BawldGuy Here: With this post and Chuck’s linked post now in the can, I can write a post next week about how to use this info strategically. There is a ton of potential synergy available when used with other investment strategies. I think you’ll find it as surprising and fascinating as I have. There are some real solid gold opportunities here.
Related posts:
- Real Estate Investors – Not Always Advisable to Use Accelerated Depreciation
- Getting More Out of Your Depreciation When You Need It
- Barred From Using Depreciation Against Your Ordinary Income? Consider This
- When Does Depreciation Start? Are You Sure?
- The Facts About a Strategy For Offsetting Capital Gains – Not To Mention Steering Clear of Taxes
About Charles Perkins
Giving wiring, plumbing and other support for fixtures and personal property the same life as the fixtures and personal property these items support in a manufacturing or other business property makes sense. You expect to pull out or significantly alter the wiring and plumbing when you change out the fixtures and personal property attached to them. The economic life is much shorter than the physical life of these components.
I don’t see offhand why the life of items that are supportive of the basic structure in a single family home or apartment building should have a life other than the average 27.5 year life assigned to the structure. You don’t change the wiring and plug behind the range when you change the range. Can you explain in more detail? Is there case law that supports the breakout of these items in residential properties? Has the IRS challenged this approach?
In addition, how are you running your cost seg analysis? Are you using a canned building cost program, similar to what an insurance company uses? If you break out the shorter-lived items, are you permitted to use the average life for the clearly structural components?
I’m not saying you are wrong. The IRS regs and the case law are not exactly clear or consistent. I’m just wondering how accepted the practice is and if it has been challenged.
Cost segregation studies have been done for many years primarily though on large multi-million dollar projects. Small residential projects sometimes have utilized these cost studies, but much less often generally because it can be quite costly.
Special purpose mechanical and electrical is defined in revenue ruling 69-558 as follows
Items installed specifically for use with personal property to which they relate. Absent the existence of these items, the
personal property would be inoperable.
Revenue Ruling 69-558, 1969-2, C.B. 4 states:
“…electrical wiring and special outlets (and plumbing lines)
…leading directly to, within, and interconnecting with items of
machinery or equipment are not parts of the electrical (and
plumbing systems), but are parts of the particular items of
machinery or equipment to which they directly lead, are within, or
interconnect…”
The Hospital Corporation of America case further clarified this revenue ruling.
There are grey areas to consider when doing a cost segregation study, but the concept of special purpose mechanical and electrical systems is fairly clear though one might argue how the ruling should be applied.
I do not use a canned program when doing a cost seg analysis. I have several years of experience as an estimator and am very familiar with most of the components found in buildings. I utilize blueprints, drawings, photos, inspections, appraisals and other data to breakout the components. I also use RS Means Contractors – Detail Cost guide to value the various components along with other evidence that I’m able to obtain.
The IRS has an extensive audit technique guide they use for auditing cost segregation studies. There is no uniform requirement for these analyses, but there are some basic requirements that they will look for. If you are curious what the IRS might look for you might want to do a search on the IRS website for cost segregation study and you will find this audit guide.
I will expand on special purpose mechanical/electrical systems in a future post.