Basis for reuse
This month we discuss another brownfield finance tool - depreciation. This tool can help private brownfield developers convert military bases formerly owned by the government to civilian use, and return other brownfields to productive reuse.
Depreciation of brownfield buildings and equipment
"Depreciation" refers to a specific type of income tax deduction provided by the tax code to property owners. The Internal Revenue Service (IRS) has divided depreciable assets into different classifications. Various parts of a parcel of real property fit within different classifications. Each class of assets is depreciated at a specific rate, which is calculated as a percentage of the asset's value.
Classes of assets
Land. Land cannot be depreciated for tax purposes. Therefore, no percentage of the land's value may be deducted from the owner's gross income. So, if a plot of land is worth $2 million, the owner - either an individual, a corporation, a limited liability partnership or any other type of business entity - cannot deduct a single dollar from its gross income for depreciation.
Buildings. These provide owners with a depreciation deduction. Buildings have been depreciated over 31.5 and 39 years. This means that the purchase price of a building has been written off over this period of time. So, if a building is depreciable over 31.5 years and is worth $2 million, the owner can initially deduct $63,492.06 from its gross income. If the owner is in the 40-percent tax bracket, $25,396.82 that would have been paid in taxes that year will be deferred.
Fixtures, machinery and equipment
. These all fit within other classifications. Assets within these classifications are generally depreciated more quickly, over periods such as five or seven years. The rationale is that these assets have a shorter life than buildings. Suppose the property houses machinery or equipment that can be depreciated over five years. Let's also suppose that the value of the equipment is $2 million, the same as the value of the land and building. The owner can deduct $400,000 from its gross income in its first year of ownership. If the owner is in the 40-percent tax bracket, this means that $160,000 in taxes that would have been payable that year are not.
It pays to classify a property's various assets properly. The value of buildings must be carefully segregated from the depreciable assets they house, just as the value of buildings must be carefully segregated from the land on which they are built.
The basis for depreciation
We spoke with several members of the real estate group of Ernst & Young (E&Y), one of the nation's largest accounting firms. Leo Cairns is a manager in E&Y's Philadelphia office. We also spoke with Patrick Hughes, a senior tax consultant in E&Y's real estate group. Cairns said that his firm provides "cost segregation studies." E&Y's staff of architects and engineers segregate assets into their appropriate classes. They work with other professionals to properly allocate the purchase price of a property between land, buildings, equipment and other classifications provided by the IRS.
The value of each asset at the time of its acquisition is its "basis." Basis is the starting point from which depreciation is claimed. It refers to the original purchase price of a particular component of a property. As depreciation is deducted each year, the basis of the asset is reduced by the amount of the depreciation claimed. The result is the "adjusted basis." When the owner sells the property, its profit consists of the sales price minus the adjusted basis. In this way, the government recaptures the depreciation deduction.
Tax professionals use depreciation to defer taxes. Depreciation resembles an interest-free loan. A depreciation deduction provides brownfield owners with temporary - i.e., repayable when the property is sold - but interest-free use of money. This money can be used in the expensive process of brownfield revitalization.
People and news
Tom Mix, a brownfield coordinator with the U.S. Environmental Protection Agency's Region 9, described a site in California. This site was scheduled to hold 10 million square feet of office space, 2,700 new units of mid- to high-rise apartments and other reuses. The cleanup proposed by the developers did not meet the approval of state regulators. The developers continued trying to gain approval for their more cost-effective remediation plan.
While the debate continued, the project stalled and the local real estate market cooled. Real estate is a very sensitive business; a development that will proceed today may not pass economic or political muster tomorrow. Depreciation is one of the tools you can use to provide more flexibility during expensive remediation projects, thereby avoiding this type of delay.
Lessons learnedThe gross income from a brownfield isn't what matters. The net income is what an owner uses to fund revitalization.
Brownfield developers and their professional advisors must use every tool at their disposal to make brownfield revitalization viable. Failure to do so can jeopardize redevelopment plans.
This article originally appeared in the 07/01/1999 issue of Environmental Protection.