An abandonment study can legitimately generate a windfall of depreciation for the owner of investment or owner-occupied real estate. By increasing depreciation, substantial tax reduction can be effected. An abandonment study is appropriate when it is necessary to demolish or substantially renovate tenant improvements within a building. When existing tenant improvements are demolished, the undepreciated basis for the tenant improvements can be deducted in the year in which it is realized they no longer have value or when the demolition occurs. The current owner can deduct the undepreciated cost of the tenant improvements even if the prior owner disbursed payments for the tenant improvements. The tax cut available from improvements installed by previous owner or tenant is not intuitive. An abandonment study identifies the value of the demolished or renovated property.
If the current owner paid for the tenant improvements, the remaining cost basis is simple to calculate in an abandonment study. However, if a prior owner paid for the tenant improvements, it is unlikely cost data is available to the current owner. Further, even if cost is available to the current owner, that cost is not necessarily the current owner’s initial or undepreciated cost basis. (For an abandonment study, it is not relevant whether the current owner paid for the tenant improvements. If the prior owner or even the tenant paid for the tenant improvements, and the owner did not expect the tenant to be leaving at the time of acquisition, an abandonment study identifies the tenant improvements as a portion of the assets purchased.) Tax help can originate from unexpected sources.
By obtaining an abandonment study, the current owner can determine the undepreciated cost basis for the tenant improvements which are being abandoned. This abandonment study will identify the replacement costs of the assets, extract an appropriate cost basis for the improvements being abandoned from the current owner’s purchase price and calculate a depreciated cost basis which may be deducted from the tenant improvements. Examples of tenant improvements often identified in abandonment studies which are unlikely to benefit a subsequent tenant include:
- 20,000 square foot bank in an area which has an excessive number of banks with an average of 3,000 square feet;
- 5000 square feet of space for one physician
- 50,000 square feet of space mostly apportioned to very small patient rooms for health insurance physicals;
- another format or layout which is atypical.
Let’s consider an example:
Stan Smith purchased a 100,000 square-foot office building for $10 million in 2000. In 2004, the XYZ Company which leased 40,000 square feet of space filed for bankruptcy and vacated the space. The prior owner had spent $1 million for tenant improvements. An abandonment study analysis concludes the appropriate cost basis for the new owner is $800,000. The new owner has been depreciating all the improvements over 39 years. An abandonment study identifies the undepreciated cost basis for the tenant improvements for the XYZ Company at $717,949 ($800,000 x 35/39). The owner can deduct this amount when he realizes the improvements have no value or when the improvements are demolished.
Depreciation of tenant improvements is a difficult process to execute effectively. Accurately depreciating tenant improvements can substantially reduce income tax liability and increase both cash flow and total investment return.
O’Connor & Associate’s Federal Tax Reduction department is a national leader in the area of abandonment studies and cost segregation. Our team of advisers and full-time appraisers dedicated to abandonment studies and cost segregation assignments have counseled clients and prepared cost segregation reports for thousands of properties. O’Connor & Associates is the largest independent appraisal firm in the southwestern US and has over 50 full-time staff members engaged in abandonment studies, valuation and market study assignments. Their expertise includes valuing commercial and single-family real estate, business personal property, business enterprise value, purchase price allocation for businesses, valuation for property tax assignments, partial interest valuation, estate tax valuation, expert witness testimony and valuation for condemnation. They have performed over 20,000 appraisals since 1988.