Cost segregation is a tax strategy for rental property owners that requires a engineering based study to separate personal property and land improvements from the real property for tax purposes. This allows the property owner to depreciate personal property and land improvement elements over a much shorter timeframe than would otherwise be allowed.
Currently, rental property depreciates over 27.5 years, while commercial property depreciates over 39 years. The tax strategy goal of the property owner is to attribute as much of a property’s value as possible to personal property or land improvement categories. The parts of the property designated as personal property can be depreciated over 5-7 years, while land improvements are depreciated over 15 years.
However, the 2017 Tax Cuts and Jobs Act re-introduced bonus depreciation and expanded the definition of eligible property to include land improvements and used items that were not previously held by the new owner. Property purchased between September 27, 2017 and December 31, 2022 that is identified as either personal property or land improvements through a qualified cost segregation study can be fully depreciated during the year of purchase.
Land improvements in a cost segregation study include:
- parking lots, paved areas
- driveways and decking
- site utilities
- sidewalks, concrete stairs, curbing
- storm drainage
- fencing, block walls, retaining walls, dumpster enclosures
- landscaping including trees, plants, shrubs, mulch, rock, sod
- security lighting.
Cost Segregation: Land Improvement Techniques
When it comes to initiating a study, there are several avenues owners can take in order to maximize savings. This can include:
- Actual Cost Records Engineering – This entails a methodical approach by relying on documentation related to construction. Documentation can include change orders, job reports, invoices, blueprints, and other items involving the construction process.
- Survey or Letter – Utilizing this method, contractors are asked to provide information regarding specific projects undertaken on your property. This information is typically obtained via letter or survey.
- Detailed Engineering Cost Estimate – While similar to the actual costs approach, this technique makes use of estimated costs to undertake a study. This can be useful in the event that cost records are not readily available at the time of the study.
- Residual Estimation – For a speedier analysis, residual estimation can be a good option. This process uses short-term asset costs (such as for five or seven year old properties) to create an assessment. While this method can be much simpler, it also tends to be far less accurate than other options.
Land Improvements: 15-Year Depreciation
Let’s consider an example of an apartment building that was purchased for $10 million dollars. A cost segregation study determines that the below amounts are attributed to land improvements:
Prior to the 2017 Tax Cuts and Jobs Act, the land improvements for this residential building would be depreciated over fifteen years at $60,000 per year. Now, it is eligible to be depreciated at 100% during the first year – resulting in a $900,000 deduction from the earnings of the company that are taxable.
To continue the example, let’s assume that ABC company has earnings of $4,000,000 for the year and is taxable in the 21% flat-tax bracket for corporations. If ABC chooses to depreciate the land improvements over fifteen years and does not elect bonus depreciation, their taxes will be calculated as follows:
- $4,000,000 EBITDA – $60,000 Land Depreciation = $3,940,000 Taxable Income
- $3,940,000 Taxable Income x 21% income tax = $827,400 Tax Expense
However, if ABC Corporation elects to depreciate the land improvements fully in the year of purchase, they will have a lower tax bill, as indicated below:
- $4,000,000 EBITDA – $900,000 Land Improvement Depreciation = $3,100,000 Taxable Income
- $3,100,000 Taxable Income x 21% income tax = $651,000 Tax Expense
Land Improvements: IRS Discussion
Section 167 of the Internal Revenue Service Code establishes the general rule that a depreciation deduction is a reasonable allowance for the wear and tear (or exhaustion) and obsolescence of specific property used in a trade or business, or of property held for the production of income.
Section 167(a)-2 of the Income Tax Regulations states that depreciation will not apply to land apart from the improvement or physical development added to the land, which has a limited period of use and experience wear and tear. With regards to landscaping as a depreciable land improvement, Revenue Ruling 74-265, 1974-1 C.B. 56, indicated that landscaping that would be simultaneously retired with a building would be considered a depreciable land improvement. Other improvements unaffected by the buildings retirement and not subject to other wear and tear would be considered part of the taxpayer’s basis in land.
The ruling notes: “The landscaping for shrubbery and grass is interrelated to the apartment buildings by reason of the site plan design, and physical layout and construction. The landscaping is not similar to the general site grading but is similar to grading that would be retired if the apartment building were removed. The landscaping is so located as to constitute a primary and integral part of the overall apartment facilities.”
The ruling held that landscaping consisting of the perennial shrubbery and ornamental trees immediately adjacent to the buildings is depreciable property under Section 167, since the replacement of the buildings will destroy this landscaping.
Furthermore, in Trailmont Park Inc., TC Memo 1971-212, the court held that the costs of clearing, grading, terracing and landscaping were an integral part of the construction and development of a mobile home park and were depreciable over the same period as the pads, patios, and other improvements. In its Action on Decision, the IRS conceded that: “The useful life on the landscaping is comparable to that of other depreciable improvements such as water and sewer lines and paving since the construction required in replacing these items would probably destroy much, if not all, of the landscaping.”
The landscaping surroundings this facility would be destroyed if the building and other depreciable land improvements were removed. Therefore, using the rationale of Rev. Rul. 74-265 and the IRS’s position in is Action on Decision of the Trailmont Park, Inc. case, the cost of the landscaping should be classified as depreciable land improvements. Accordingly, the paved area, sidewalks, concrete retaining walls, steel railings, site utilities and landscaping qualify as Asset Class #00.3 (Land Improvements) for tax depreciation purposes. Make sure that you use a template to track these items.
Land Preparation Revenue Ruling 65-265, 1965-2, C.B. 52, supports depreciating the costs associated with excavation and grading as part of the cost of the asset for which they are associated. Revenue Ruling 65-265 states that the costs relating to excavation, soil removal and grading that are necessary for the required setting of the building structure and the roadways are included as part of the cost of those assets.
Accordingly, they should be included in the depreciable basis for the building and roadway. Revenue Ruling 68-193, 1968-1, C.B. 79, clarified Revenue Ruling 65-265 stating: “The cost paid or incurred for the grading, (and excavation) are depreciable since the grading (and excavation) would be retired, abandoned, or replaced with the depreciable asset with which it is directly associated…”
Revenue Ruling 74-265, 1974-1, C.B. 56; and Trailmont Park, Inc. TC Memo 1971-212 further support this position. As a result, the site preparation costs for the paved areas and buildings are essentially part of the cost of construction of these items and should be depreciated as part of the aforementioned items. Accordingly, the land preparation costs related to the land improvements described above qualify as Asset Class #00.3 (Land Improvements) for tax depreciation purposes.