ANOTHER TWIST OF COST ALLOCATION STUDIES!!!

I have written about Cost Allocation Surveys or Studies before but, for the Apartment Building owners, and for many other businesses, it is an amazing tool under the current tax laws.  And I am writing this on August 26, 2020 for reference to the current tax laws.

Let’s talk about Apartment Buildings.  I have a few thoughts that I would like to bring up about the allocation of the land and building when you purchase the property.  When you purchase an existing Apartment Building you are buying land and building.  The land is not depreciable because it’s going to be there forever.  The building will be depreciated over 27 ½ years according to the Internal Revenue Code.  The first question that has to be answered by your accountant is how much of the purchase price is to be allocated as land and how much of the purchase price is to be allocated to the building.  Accountants normally go to the county property tax bills which show the allocation of land to building.  The IRS likes this method.  BUT this is not always the best source to go to.  Sometimes the amount of the land exceeds the amount of the building and we do not want that.  A lot of accountants just allocate 50% to the land and 50 % to the building.  Why don’t you get an appraisal in order to allocate the land and the building?  The increased value of the structure will give you increased depreciation and tax savings to offset the cost of the appraisal.  

But there is another approach.  If you build you have a clear-cut delineation between land and building.  Typically, in Southern California, the land will cost you $3 million and the construction may be a total of $17 million for a total of $20 million.  Then you allocate 15% to the land and 85% to the building.  Now, that’s an allocation that should put a smile on your face.  And, when the project is complete and you have a full Apartment Building, the value of the building should be around $23 million or $24 million and you created instant wealth.  It took you 3 years to do it but that’s not a bad return on your investment.

Now let’s turn our attention to the Cost Allocation Survey.  The Apartment Building is made up of real property and tangible personal property.  The real property is the foundation, the drywall and all of the components of the building.  The tangible personal property are the appliances and the doors and anything that can be removed from the property without damaging the structure.  When you purchase or build an Apartment Building you want the value of the tangible personal property to be high and you want the value of the structure to be low.  The reason is, under the current tax laws, you can write off up to $1 million of the tangible personal property as bonus depreciation in the year that the building becomes operational.  This can create a large tax loss, known as a net operating loss, that can either be carried back or carried forward to offset other income.  So, you can either get large refunds or not pay taxes in the future for a number of years.  And that is where the story usually ends.

But the smart real estate investor and accountant (CPA) take this a few steps further.  When you go to sell the Apartment Building that has given you cash flow in the form of Net Operating Income (NOI) over the years and has appreciated over the years, depreciation is as much of a consideration as it was when you bought the building.  You should do another Cost Allocation Study when you sell the Apartment Building because this time you want a lower value for the tangible personal property and a higher value for the real estate.  Most companies that do cost allocation surveys will include the second survey in the price of the first.  The reason is that with a higher value of the tangible personal property you will have a gain and that gain is ordinary income.  That is not good.  When you sell the real estate, you will also have a gain and that gain is a capital gain.  Ordinary income is taxed at a higher rate than capital gain income.  But this all makes sense.  When you build the building all of the appliances are new and valued at cost.  So, a dishwasher that was purchased for $450 is valued at $450 in the first cost allocation study.  What is that used dishwasher worth 10 or 15 years later?  Virtually nothing.!!!  So, there is virtually no gain.

When you buy an Apartment Building the value of that dish washer has to be determined by an expert.  The company who performs the Cost Allocation Survey.  You cannot do it; you do not have the expertise.  And the results of the Cost Allocation Survey are so important because they mean how much depreciation you can take and that means money in your pocket.

My name is PAUL LEVINE and I am a Commercial Realtor in Southern California from Santa Barbara to San Diego.  I can always be reached at (818) 298 – 4000 or at “PLevineRealtor@gmail.com”.  My specialty is building, buying and selling Apartment Buildings for my investor clients.