Jerry Ferch

There is a problem plaguing owners of commercial buildings.  It’s an ongoing process of cost basis inflation and it goes like this:

An investor buys a building for $4,000,000, then guts it and spends $2,000,000 to remodel.  The owner depreciates the remodeled property @ 39-years straight line, with a cost basis that is now $6 million,  $2 million over the cost, but the building is no larger than before!  So, is it right for the basis after remodeling to be 50% more than the purchase cost?  Probably not, since the tear-out had to be worth something.  While it may be common sense to reduce basis by the value of the tear-out, thousands of building owners inflate their cost like this every year.

Fortunately, there is a solution . . . The 178-page Small Business Job Protection Act of 1996 allows the expensing of the remaining cost basis of a buildout when it is removed after a tenant leaves.  This little known tax law alleviates the cost basis inflation that occurs when incremental capital costs are piled one on another for the same rentable space, even though prior buildouts are torn out. This provision gives the property owner well-deserved tax relief, since they can reduce reportable income by taking the value of the demolished improvement as a tax loss and as a subtraction from the property’s cost basis.  This adjustment applies for any commercial property owner who holds title to buildout improvements in their building.  The part of the law addressing this issue is Section 1121, Point (a), Subsection (B) which says “Lessor improvements . . . abandoned at termination of lease . . . which are irrevocably disposed of or abandoned by the lessor at the termination of the lease . . . shall be treated for purposes of determining gain or loss under this title as disposed of by the lessor when so disposed of or abandoned.” This means the property owner can take an expense equal to the remaining value on the books for the part of the building that is removed.  For tax reporting, removal of the buildout is treated as abandonment, as per IRS Publication 544 (“Sales and Other Dispositions of Assets”) and the loss is filed on IRS Form 4797, Part II, Line 10.

In conclusion, as part of a Cost Segregation Study, a renovation tear-out valued for tax loss and can be immediately subtracted from the cost basis of the property.  This creates an immediate reduction in reportable income and a corresponding reduction in taxes.

PLUS, here is another substantial value to this strategy: When the property is sold (assuming it sells for more than cost), since the basis of the property was reduced by the value of the tear out, that amount is treated as a long term capital gain which is taxed at a much lower rate than if it had been depreciated and recaptured as ordinary income. Currently, recapture of ordinary income is taxed at nearly double the rate for capital gains.  We have performed this service within Cost Segregation Studies for various clients, yielding first year tax losses in the hundreds of thousands.  Also, a Loss of Use Analysis can just value a tear-out without cost segregation. When we provide a free no obligation estimate of cost segregation for any property, when appropriate we will also estimate the loss of use bonus tax reduction.