As a commercial real estate broker, one of the tasks that I perform most often with clients is an explanation of the benefits of owning commercial real estate over leasing. From an economic standpoint, the benefits of ownership will generally always outweigh those of leasing space.
Like home ownership, an obvious benefit of ownership is the accrual of equity in the property. For businesses, however, the tax benefits of ownership can also be substantial. In addition to equity build-up and the tax deductions offered on interest payments made under a commercial mortgage, another primary benefit is the potential annual tax savings due to the deductions offered on the depreciation of a property. When a commercial property buyer’s business generates enough income to utilize these deductions, the benefits of owning real estate over leasing are significant.
Probably the most misunderstood of these benefits is property depreciation. One reason for this is the number of changes that the IRS has made to the tax code in regard to depreciation over the years. Most owners today do not understand the flexibility in the current code (in regard to depreciation) and the potential tax savings that are available to them.
I will explain how the tax code has changed over the past couple of decades. First, however, let me explain the basic theory behind commercial real estate depreciation. In allowing deductions for depreciation, the IRS is acknowledging that the improvements constructed on a piece of property will wear out, and will eventually need to be replaced. The land underneath the improvements will not wear out and need replacement. As far as the IRS is concerned, the land is there forever. Legislators have struggled for decades with determining fair methods for commercial owners to be compensated as the commercial improvements on top of the land wear out and need to be replaced.
Prior to 1986, property was classified as having a 5 or 19 year life under the Accelerated Cost Recovery System (ACS). In 1986, under the Tax Reform Act (TRA), property was reclassified as 5 or 7 year personal property, 15 year land improvements or 31.5 year real property. In August 1993, the Omnibus Budget Reconciliation Bill was signed into law. This bill extended the depreciable life of real property from 31.5 years to 39 years on a straight-line basis. As a result of the TRA of 1986, some site improvements (such as roads, and sidewalks, fences, landscaping and shrubbery) that were not eligible for special treatment under previous law will now generate tax savings since they can now be depreciated over a shorter period (15 years).
Furthermore, some components of a building are now allowed to be depreciated over shorter schedules through a process called cost segregation. Cost segregation can save commercial property owners a significant amount of money annually. The cost segregation process classifies the components of a building according to their use and expected life. The tax benefits are gained by identifying the components of a property that would normally be classified as real property and depreciated over 39 years and reclassifying them as 5, 7, or 15 year property depreciated under the 150%-200% double declining balance method.
The tax benefit is due to the time value of money concept where a dollar in the future is less valuable than a dollar in the present. Property owners can significantly reduce their “occupancy cost” by utilizing shorter depreciation schedules which give them larger tax deductions. Even the smallest businesses can use the accelerated depreciation of cost segmentation's to save thousands of dollars in taxes up-front. There also are methods an owner can utilize to continue to occupy his property once these shorter depreciation schedules run out (i.e. sale lease-back).
Cost segregation is one of several tools available that can make owning commercial property much less costly than leasing. If a business owner 1) expects to operate his/her business in a market for a number of years, 2) is fairly certain that there will not be a need to significantly expand or reduce space during this period, 3) can find a suitable location/property to purchase and 4) generates enough income in his/her business to utilize the tax savings, then the cost of owning will far outweigh that of leasing a similar property. Most commercial brokers can prepare a “lease versus own” analysis to demonstrate the comparative cost of each alternative.
For commercial property owners that would like to investigate the potential benefits of cost segregation, I suggest contacting a company such as O’Conner and Associates, a real estate appraisal and services firms. O’Conner & Associates is located at 2200 North Loop West, Suite 200 in Houston. They will provide a free analysis of your property and will demonstrate the potential annual federal tax savings you could realize by doing a cost segregation study.