Small Business Taxes & ManagementTM--Copyright 2010, A/N Group, Inc.
Depreciating equipment is usually straightforward. You buy a computer, you depreciate it over 5 years (or take the Section 179 expense option and write it off in the first year). Office furniture is just as easy, but the recovery period is 7 years. Even large pieces of equipment rarely pose a problem. Things start to get complicated if you purchase real property or a collection of equipment in a bulk purchase. These purchases can consist of different types of property with different recovery periods.
This is the problem most taxpayers will encounter, can cause the most complications, and has the largest dollar consequences.
Lets start out with the simplest and most common situation. You purchase a rental property for $350,000. If it's a residential property, the recovery period is 27.5 years; nonresidential is 39 years. (It doesn't matter that the building is brand new or already 40 years old.) But you purchased land along with the building and land is not depreciable. You've got to allocate the purchase price between the land and the building. The easiest way out is to use the local property tax assessments. The assessment will almost always show the split between land and building. Use the percentage for the building and apply it to the purchase price. This approach is often used by the IRS. If you use a different approach, you'll have the burden of proving your allocation is correct. Note. If you purchase land and building and demolish the building to put up a new structure, the entire purchase price has to be allocated to the land.
If the assessor's breakdown doesn't accurately represent the allocation between the land and building, you can get an appraisal. But make sure it's a qualified appraisal that will hold up should you have to go to court. In a recent case, the taxpayer's CPA made an allocation based on his general knowledge of real estate in the area. The Court rejected his opinion, and accepted the IRS's use of the local property tax assessment.
For a residential rental property, land and building are often the only two items that require allocation. In commercial real estate the breakdown is often between, land, building, and land improvements. Land improvements have a 15-year recovery period. Thus, there's an incentive to classify as much of the property in this category as possible, increasing your current depreciation deduction. Land improvements include sidewalks, parking lots, roads, sewers, bridges, fences, and landscaping shrubbery. (While residential rental properties frequently have land improvements, they're often a much smaller percentage of the purchase price.) Unfortunately, you won't see that broken out on the town's real estate bill. You'll definitely need an appraisal to determine the value. (Get some rough estimates on how much of the purchase price will qualify as land improvements and the cost of the appraisal. You might find it's not worth the breakdown.)
If you're buying an empty building, most of the items in the structure will be depreciated over the same life as the building. While that furnace may be on its last legs, the recovery period will be the same as the structure. That generally goes for any item in the building that would normally be part of the structure. For example, plumbing, bathroom fixtures, stairs, heating and air conditioning units, etc. Lighting fixtures that are attached to the ceiling or walls have the same recovery period as the building.
You may buy a building that contains tangible personal property such as floor lights, movable partitions, window blinds, desks, or, in the case of a residential rental property, household furnishings, stoves and refrigerators. These items have a shorter recovery period--generally 5 years for items in residential rental properties and 7 years for movable partitions, desks, etc. in nonresidential property. In some cases you may be able to use the Section 179 expense option on the acquired property (see Tangible Personal Property, below), expensing the entire cost of the purchase in the year acquired.
In many cases identifying property with a shorter life is relatively easy. If it's movable and meant to be moved, there's a good chance it qualifies as tangible personal property. But there are enough situations where classification isn't as easy that you should talk to your tax adviser or accountant. (Farmers need to be particularly careful. Single purpose agricultural structures such as a greenhouse usually have a shorter recovery period than nonresidential property.)
If you're buying a building that includes tangible personal property, try to identify the items in the purchase and sale agreement and allocate part of the purchase price to those items. Talk to your attorney. You might want to get a separate bill of sale for those items.
Tangible Personal Property
It's one of those, "I can't define it, but I know it when I see it". Tangible personal property consists of items you can touch (as opposed to intangible property) and is readily movable and not permanently attached to the land. Thus, a 275-gallon diesel storage tank may be mounted on a cement pad inside a shed. The pad and shed may be real property; the storage tank tangible personal and depreciable over 5 or 7 years.
If you're purchasing items from a vendor, the costs of individual items will generally be broken out. That's important, because some items may have a shorter recovery period. Of course, if you can and do use the Sec. 179 expense option, the breakdown is not as critical. If you must (or decide) to depreciate the property, the breakdown will be important for a second reason. If you can identify an item of property and know its cost, you can take a loss (or have to report a gain) if you dispose of the property. For example, Madison bought a chainsaw ($450) and a string trimmer ($175) on June 1 and decides to depreciate the items. For Madison, both items have the same life. However, on April 1 of the following year, the string trimmer is sold for $50. Madison can take a loss on the difference between the depreciated cost and the selling price. If Madison didn't know the breakdown of the costs, it couldn't take the loss until both items were disposed of.
For rental property the Sec. 179 expense option may not be available. It can only be applied to property used in a trade or business. If you're using the building for your business, tangible personal property in the building should qualify. If you're renting to others, you can use the option only if renting is a trade or business. This is an involved issue. Talk to your tax adviser.
If you're buying a group of assets from someone other than a vendor (e.g., you buy the assets from a competitor, at an auction, or as part of the purchase of a business, etc.) you should either have a bill of sale that breaks down the value to the individual assets or get an appraiser to do so.
Intangible assets include copyrights, patents, goodwill, customer lists, secret recipes, etc. You're most likely to encounter these in the purchase of a business. These items all have a 15-year life. The important consideration here is to make sure their cost isn't included with the cost of tangible assets purchased. If you're buying all or part of a business, you need competent tax advice. Talk to your tax adviser, accountant, and/or attorney.
This is another area where you could encounter an allocation issue if you rent both real and tangible personal property to the same lessee. For example, you rent office space that's fully furnished. There's no sales tax associated with leasing real property, but sales tax applies to the rental of tangible personal property. If you're renting to an unrelated party, all that may be necessary to comply with state sales tax law may be to allocate the rent between the two types of property in the lease agreement. Alternatively, have two separate agreements--one for the real and one for the personal property. As long as the allocation is reasonable, you may have satisfied state requirements. If the rent related to the personal property is a substantial percentage of the overall rent, you may want to document the allocation with market quotes.
In some cases, if the rental of tangible personal property is not a significant percentage of the overall rent, the state may not require a breakdown. As always, the rules can vary from state to state. Consult your tax adviser. Be particularly careful if you're renting to a related party and even more careful if the parties are in different states. For example, Fred is the sole shareholder of Madison Inc. and lives in New York. Fred owns and rents tangible and real property to Madison, located in Massachusetts. The important point is not to ignore the issue.
For federal tax purposes, the rental of personal property may be handled differently than that of real property. If the rental of personal property is incidental to the rental of the real property, (for example, you provide furniture in a conference room on each floor of an office building), no breakdown may be necessary. But if the rental of personal property is significant, different treatment may be required. Again, see your tax adviser to be sure.
We've omitted the fine points here. For example, electrical wiring is generally part of and depreciable over the life of the building. But if the wiring is run just for a particular machine and would be removed if the machine changed, it might have the same recovery period as the machine. Special rules apply to modifications made to buildings; tear down too much of the structure during a rehabilitation and you might have to allocate the entire purchase price to the land. As always, check with your tax adviser.
Copyright 2010 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 12/15/10