Hypothetical: A Small Commercial Building

Commercial buildings often include parking, site work, and tenant improvements. This example shows how those pieces might affect the decision.

The facts assumed

A hypothetical investor buys a small single-tenant retail building for $1,500,000. Land is assumed to be $400,000, leaving $1,100,000 of depreciable basis. The building is leased to an unrelated tenant. The investor holds it through an LLC taxed as a partnership with two members, both of whom have passive income from other real estate. The study fee quoted is $9,000.

The baseline

The $1,100,000 is depreciated over 39 years straight line, about $28,200 in a full year. In the first partial year, a mid-month convention applies, so perhaps about $14,000 to $24,000 depending on the month.

A hypothetical study result

Assume the study, using an engineering-based method, identifies the following, purely as assumptions:

The shift is $230,000 of the $1,100,000, about 21 percent, which is an assumption for this example and not a benchmark. Some buildings would shift less, some more.

First-year effect

If bonus is assumed available at 100 percent on the $230,000, the first-year deduction from those items could be $230,000. The remaining $870,000 building is depreciated at about $22,300 in a full year. The total first-year depreciation might be near $250,000 compared with a baseline near $20,000 or so. The extra is around $230,000.

Usability

The two members have passive income from other properties. Assume it is enough to absorb the deductions in the first year. If it were not, part of the deduction would be suspended. See The Passive Activity Loss Rules and Cost Segregation.

Tax value

At an assumed 30 percent combined rate, $230,000 of extra deductions may reduce tax by about $69,000 in the first year, before considering later effects. The fee of $9,000 and added preparation of a few thousand dollars are small compared with that timing effect in this hypothetical.

Later years

The short-lived items no longer produce annual deductions later. The baseline would have given roughly $5,900 per year on them over 39 years. The study version therefore has lower deductions in later years by that amount.

Exit

If the LLC sells the building in year twelve, the portion of gain attributable to depreciation on personal property and accelerated depreciation on land improvements may be taxed at ordinary rates, and depreciation on the building portion may be unrecaptured Section 1250 gain. See Hypothetical: Sale and Recapture After a Study and Unrecaptured Section 1250 Gain in Plain Terms. If the LLC exchanges into another property, some of this could be deferred, with caution about personal property. See Section 1031 Exchanges and Depreciation Recapture.

What this example illustrates

• Commercial properties with site work can have substantial land improvements.
• Usable deductions and a long hold favor the timing benefit.
• The fee is a small fraction of the potential timing benefit only because the assumed basis is large.

Cautions

If the building were $300,000 instead, the same percentage would give $63,000 of shift and the fee would matter more. See Small and Low-Basis Properties.

Variations to try

Change the land share to 45 percent and see how the depreciable basis and the shift fall. Change the shift to 12 percent. Assume only one member has usable passive income. Assume the fee is $15,000. Assume a sale in year four. Assume an exchange in year twelve. Each variation shows which assumptions have the greatest effect.

Questions the example raises

Which of the improvements were paid by the tenant? Are the site improvements older than the building's placed-in-service date? Is the personal property actually owned by the landlord? What are the lender's requirements? How will the study affect the members' K-1s? These questions belong in the scoping conversation with the provider and the preparer.

What the example leaves out

Tenant improvements, financing costs, state taxes, and any effect on the qualified business income deduction are not modeled. Real analysis would consider them.

Step-by-step recomputation with a different assumption

Try the arithmetic again with a smaller shift. Suppose the study found $110,000 rather than $230,000 in shorter classes. With the same 30 percent assumed rate, the first-year tax effect of the extra deductions would be roughly $33,000 rather than $69,000. The fee is unchanged at $9,000, plus a few thousand dollars of added preparation. The net first-year effect is still positive, but the margin over the costs is smaller, and the later reduction in deductions and the recapture at sale take a larger bite relative to it. The point is that the shift assumption, which is the most uncertain number in the analysis, has a large effect on the answer. Any real proposal should be tested with a range for that number.

Reading the numbers with the right expectations

An actual study of a real building might produce a different shift, different site costs, different tenant improvement amounts, and different classification of borderline items. The example is only a template for organizing the analysis.

Next steps

Read Commercial Properties: The Study Decision and then the Cost Segregation Decision Checklist.