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Breaking Up Is Hard To Do, But Sometimes Very Profitable
Tax and Financial News
March 2003
Breaking Up Is Hard To Do, But Sometimes Very Profitable
The first rule in taxes is, âNever make assumptions.â Aside from what âassumingâ could ultimately make out of you and me, it could also cost you big bucks!
For example, when most of us look at an empty building, we assume that everything we see will have to be depreciated over the next 39 years...well, thatâs what tax return preparers see first, but thatâs not always true. Sometimes, much of what we think is a building depreciable over 39 years can really be deducted faster.
What! How can this be? You guys always told me I had to capitalize my buildings and deduct them over 39 years. You even made me set my new air-conditioning unit as a 39-year asset and you knew it probably wouldnât last longer than 5 years!
Did any of those thoughts run through your head? All of these thoughts have run through our minds. Itâs natural to think of all the computer cables, electric wiring, concrete work and similar items that are intuitively âcomponentsâ of a building as very long lived assets, but as we will explain, they may not be.
You see, there have been a number of court cases and IRS rulings that allow building owners the opportunity reclassify certain costs to 7-year or possibly 5-year assets rather than 39-year assets. Most of these rulings take a process oriented and functional use approachs to determining the proper classification of assets.
Letâs take an example. Say you manufacture woven widgets in a large plant you just put in service on January 1, 2003. The plant cost $10,000,000, excluding new machinery, and the main reason you built the new plant was to accommodate your oversized woven widget weaving machines. In fact, you nearly blew a gasket when the architect told you how much the plant would cost, but when she explained that the plant floors underneath the woven widget weaving machines would cost $750,000 each so they could support the weight of the weavers, and the electrical wiring to support the machines would cost $250,000 for each machine, you and your banker grudgingly accepted the cost estimate.
Even though your banker will give you a 10-year loan that assumes the actual payback is over 30 years, youâre still talking about $732,000 per year in debt service. Thatâs pretty stout for your companyâs current cash flow. Itâs doable, but still pretty stout considering your other obligations. Even worse, youâll have to deduct the costs over the next 39 years thanks to the U.S. Congress. You wake up in a cold sweat every night wondering how you are going to make the loan payments and pay all the taxes that will be due. Only after a 30 minute mantra of âhave faith; it will all work out,â are you able to go back to sleep.
You keep thinking thereâs something you can do, but no one has any magic answers. That is, until you happen to mention your fears one day on the golf course to your CPA. When you mention that the only reason for about half the cost of the plant is to accommodate the new machinery, the CPAâs eyes light up so bright that you feel you can almost see fireworks and sparklers coming out of the top of his head.
âWow,â he says, âyou donât have to write the whole cost off over 39 years. Since the IRS lets you depreciate your woven widget weavers over five years, anything you install just to support your equipment is considered part of the machinesâ cost and can be written off over 5 years. Thatâs easily $5,000,0000 we can reclassify to 5-year property. Get me the plans and weâll take a look at just what we can do.â
You call your secretary and have the plans sent to the CPAâs office and leave the 19th hole in a much better frame of mind. Sometime between dinner and bed, though, you start thinking that youâre really not in any better shape. Now, in addition to the building cost, your CPA has figured out a way to bill you more! And, just what will you get for this expense? Youâll still only get a deduction of $10 million. Sure, it may come faster, but it youâll still deduct only $10 million.
You stop celebrating, take two aspirin and call your CPA in the morning. After you stop yelling at him for taking advantage of you, he explains the situation. He tells you something you already know, but donât think of much in your day-to-day business. He reminds you that even though total depreciation stays the same over 39 years, $5 million gets written off in 5 years and save more taxes on the front end. Since a dollar today is worth more than a dollar 39 years from now, you actually make out better.
He also tells you that he took a look at the building plans last night and computed a preliminary discounted value of the tax savings if you change depreciation methods. In fact, he was just about to call you. Assuming a 7% discount rate and reclassification of $5,000,000 to 5-year property, the net present value of deferring the tax payments will be around $890,000. He estimates the net present value of the first yearâs savings is about $660,000.
You hang up, stop worrying and take a call from your sales manager. It looks like his projections were a little off. It seems 2003 sales will double over 2002 instead of increasing only 10%. Man, life is sweet!
Does all of this sound a bit far-fetched? Itâs not really a fantasy. In fact, this scenario is played out all over the United States every day and guess what â itâs legal. A series of court and IRS rulings allow taxpayers the ability to reclassify costs in a building based on their use. Even better, depending on the industry they are used in, what you think are 7-year assets may actually be 5-year assets.
Because legislation passed in the wake of 9/11 provides for an immediate expensing of 30% of the cost of qualifying property, reclassifying 39-year property to 7-year or 5-year property has tremendous potential savings. The assets this applies to must be purchased between September 10, 2001 and September 11, 2004 and put in service by January 1, 2005. The in-service date is extended for certain self-constructed assets.
Donât worry if you purchased the building in 1990, because the IRS has in place a procedure that will allow you to change your method of accounting for the asset depreciation. Because of this, âsegregatingâ costs based on asset use makes sense for any real property purchased or built since 1987.
In the past, the effects of a change like this would have to be reported over 4 years. However, recent Revenue Procedures allow certain taxpayers to take the full effect of these type changes in the year of the change. In our example, assume the discussion didnât occur until the middle of 2004. That means you would have deducted $2,323,050 less in depreciation than your should have. Instead of taking a deduction of $1,248,200 in 2004, you would deduct $3,571,250.
The bottom line to all of this is you may very well have a potential to greatly accelerate your depreciation on longer lived assets if you properly segregate the costs of those assets based on their true uses. The savings can be substantial, but you must act soon to realize the full potential of the savings. Given that this is a win-win situation, we urge you to discuss the possibilities with us sooner rather than later. Weâre here to help by showing you how to profit from âbreaking upâ the cost of your buildings.
Have a great March!
For example, when most of us look at an empty building, we assume that everything we see will have to be depreciated over the next 39 years...well, thatâs what tax return preparers see first, but thatâs not always true. Sometimes, much of what we think is a building depreciable over 39 years can really be deducted faster.
What! How can this be? You guys always told me I had to capitalize my buildings and deduct them over 39 years. You even made me set my new air-conditioning unit as a 39-year asset and you knew it probably wouldnât last longer than 5 years!
Did any of those thoughts run through your head? All of these thoughts have run through our minds. Itâs natural to think of all the computer cables, electric wiring, concrete work and similar items that are intuitively âcomponentsâ of a building as very long lived assets, but as we will explain, they may not be.
You see, there have been a number of court cases and IRS rulings that allow building owners the opportunity reclassify certain costs to 7-year or possibly 5-year assets rather than 39-year assets. Most of these rulings take a process oriented and functional use approachs to determining the proper classification of assets.
Letâs take an example. Say you manufacture woven widgets in a large plant you just put in service on January 1, 2003. The plant cost $10,000,000, excluding new machinery, and the main reason you built the new plant was to accommodate your oversized woven widget weaving machines. In fact, you nearly blew a gasket when the architect told you how much the plant would cost, but when she explained that the plant floors underneath the woven widget weaving machines would cost $750,000 each so they could support the weight of the weavers, and the electrical wiring to support the machines would cost $250,000 for each machine, you and your banker grudgingly accepted the cost estimate.
Even though your banker will give you a 10-year loan that assumes the actual payback is over 30 years, youâre still talking about $732,000 per year in debt service. Thatâs pretty stout for your companyâs current cash flow. Itâs doable, but still pretty stout considering your other obligations. Even worse, youâll have to deduct the costs over the next 39 years thanks to the U.S. Congress. You wake up in a cold sweat every night wondering how you are going to make the loan payments and pay all the taxes that will be due. Only after a 30 minute mantra of âhave faith; it will all work out,â are you able to go back to sleep.
You keep thinking thereâs something you can do, but no one has any magic answers. That is, until you happen to mention your fears one day on the golf course to your CPA. When you mention that the only reason for about half the cost of the plant is to accommodate the new machinery, the CPAâs eyes light up so bright that you feel you can almost see fireworks and sparklers coming out of the top of his head.
âWow,â he says, âyou donât have to write the whole cost off over 39 years. Since the IRS lets you depreciate your woven widget weavers over five years, anything you install just to support your equipment is considered part of the machinesâ cost and can be written off over 5 years. Thatâs easily $5,000,0000 we can reclassify to 5-year property. Get me the plans and weâll take a look at just what we can do.â
You call your secretary and have the plans sent to the CPAâs office and leave the 19th hole in a much better frame of mind. Sometime between dinner and bed, though, you start thinking that youâre really not in any better shape. Now, in addition to the building cost, your CPA has figured out a way to bill you more! And, just what will you get for this expense? Youâll still only get a deduction of $10 million. Sure, it may come faster, but it youâll still deduct only $10 million.
You stop celebrating, take two aspirin and call your CPA in the morning. After you stop yelling at him for taking advantage of you, he explains the situation. He tells you something you already know, but donât think of much in your day-to-day business. He reminds you that even though total depreciation stays the same over 39 years, $5 million gets written off in 5 years and save more taxes on the front end. Since a dollar today is worth more than a dollar 39 years from now, you actually make out better.
He also tells you that he took a look at the building plans last night and computed a preliminary discounted value of the tax savings if you change depreciation methods. In fact, he was just about to call you. Assuming a 7% discount rate and reclassification of $5,000,000 to 5-year property, the net present value of deferring the tax payments will be around $890,000. He estimates the net present value of the first yearâs savings is about $660,000.
You hang up, stop worrying and take a call from your sales manager. It looks like his projections were a little off. It seems 2003 sales will double over 2002 instead of increasing only 10%. Man, life is sweet!
Does all of this sound a bit far-fetched? Itâs not really a fantasy. In fact, this scenario is played out all over the United States every day and guess what â itâs legal. A series of court and IRS rulings allow taxpayers the ability to reclassify costs in a building based on their use. Even better, depending on the industry they are used in, what you think are 7-year assets may actually be 5-year assets.
Because legislation passed in the wake of 9/11 provides for an immediate expensing of 30% of the cost of qualifying property, reclassifying 39-year property to 7-year or 5-year property has tremendous potential savings. The assets this applies to must be purchased between September 10, 2001 and September 11, 2004 and put in service by January 1, 2005. The in-service date is extended for certain self-constructed assets.
Donât worry if you purchased the building in 1990, because the IRS has in place a procedure that will allow you to change your method of accounting for the asset depreciation. Because of this, âsegregatingâ costs based on asset use makes sense for any real property purchased or built since 1987.
In the past, the effects of a change like this would have to be reported over 4 years. However, recent Revenue Procedures allow certain taxpayers to take the full effect of these type changes in the year of the change. In our example, assume the discussion didnât occur until the middle of 2004. That means you would have deducted $2,323,050 less in depreciation than your should have. Instead of taking a deduction of $1,248,200 in 2004, you would deduct $3,571,250.
The bottom line to all of this is you may very well have a potential to greatly accelerate your depreciation on longer lived assets if you properly segregate the costs of those assets based on their true uses. The savings can be substantial, but you must act soon to realize the full potential of the savings. Given that this is a win-win situation, we urge you to discuss the possibilities with us sooner rather than later. Weâre here to help by showing you how to profit from âbreaking upâ the cost of your buildings.
Have a great March!
These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.
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