Land Depreciation: a case study

A number of years ago I had 840 acres of premier hunting land listed for sale. It had three private lakes and was a veritable duck & goose factory; not to mention that it was overrun with trophy-sized deer. Located in the middle of a triangle between Ann Arbor, Michigan; Toledo, Ohio; and Chicago, Illinois; this was the perfect, I mean perfect, property for a private hunt club. But I couldn’t get it sold. Every high net-worth person I spoke to said, “Sounds good – but that’s a lot of money for hunting and you can’t depreciate land.”

I scheduled an appointment with a CPA in a national firm. I showed him a map marked with the location of the property. The map was an oil exploration map showing all of the wells that had been drilled in the area, including the nearby Albion-Scipio field. That field is the most productive oil and gas producer east of the Mississippi; having produced more than 150-million barrels of oil, and billions of cubic feet of natural gas.

The Albion-Scipio followed a 3,500-foot deep fracture that ran northwest to southeast, just 5 miles west of my listing.

My map also showed the early discoveries of a new field; the Stoney Point. The Stoney Point field followed a fracture that paralleled the Albion-Scipio. The new field was on a course that, if it continued, would take it right through the center of the 840 acres.

Up to that point prospective buyers were unimpressed with the new field. “The oil business is sheer speculation,” was correctly said by all.

I was familiar with oil exploration and briefed the CPA on the business. I showed him my map with the projected path of the new field, charted by a geologist in the oil industry.

It’s well known that with producing wells there are tax deductions based on “depletion,” but no “depreciation” that I knew of when there was not a producing well. I challenged the CPA; “There must be some way we can use this information to justify depreciation.”

He phoned another office and we held a conference call with the firm’s expert in the oil industry, who came up with the solution.

“Allocate the purchase price, separating the surface rights and the sub-surface rights. The sub-surface rights (she spoke only of oil and gas) are depreciable over a five year period.”

Subsequently, any time I ran that past a prospective buyer I would emphasize the usual “may qualify – run it past your CPA and attorney.” The immediate response would invariably include something about the real estate broker chewing loco weed, but once they did their research they would phone their client and say, “By God – he’s right.”

Shortly thereafter, I sold an 840-acre hunt club I had listed. After going through the usual “he’s crazy” scenario, the attorney added an addendum to the sales contract allocating the purchase price, which in this case, did not matter to the seller (more on that in a future article).

The buyer was very aggressive. Of the $2,100,000 purchase price he allocated $600,000 for the surface rights and $1,500,000 for the sub-surface rights (oil, gas, minerals, sand and gravel). Those rights the buyer depreciated over a five year period. That is a $300,000 per year income tax deduction on hunting land!

Discuss this with your attorney and CPA prior to your next land purchase. You may not be able to come up with a justification for allocating the purchase price – but if you can…

You can’t depreciate land? Come on.

Historically, it has been taught that you can depreciate structures, but you can’t depreciate the land underneath. If you accept that premise you may be paying too much Income Tax. There are most likely tax deductions available, and there may well be tax credits.

You must follow Federal guidelines, of course, but if you take advantage of cost segregation you may:

• Reduce your current tax burden
• Convert ordinary income to capital gains income.
• Defer income on the gain until you sell the property, at which time it can be further deferred with a like-kind exchange (subject of a future blog).
• File an amended return and take the increased depreciation in the previous year(s).

Cost segregation:

It is becoming common practice to hire a firm with expertise in segregating the structure on paper in order to take advantage of shorter depreciation schedules on certain parts of the structure. Following are two paragraphs taken directly from the IRS web site. Note the reference to “land improvements”

http://www.irs.gov/businesses/article/0,,id=134122,00.html

Cost Segregation Audit Techniques Guide – Chapter 1 – Introduction

In order to calculate depreciation for Federal income tax purposes, taxpayers must use the correct method and proper recovery period for each asset or property owned. Property, whether acquired or constructed, often consists of numerous asset types with different recovery periods. Thus, property must be separated into individual components or asset groups having the same recovery periods and placed-in-service dates in order to properly compute depreciation.

When the actual cost of each individual component is available, this is a rather simple procedure. However, when only lump-sum costs are available, cost estimating techniques may be required to “segregate” or “allocate” costs to individual components of property (e.g., land, land improvements, buildings, equipment, furniture and fixtures, etc.). This type of analysis is generally called a “cost segregation study,” “cost segregation analysis,” or “cost allocation study.”

So what are land improvements? The IRS says they can be: I.R.C. §1245 property (shorter cost recovery period property) or §1250 property (longer cost recovery period property).

They vary with the industry; from logging, to golf courses, to car dealerships, and everything in between; but be confident they can be found in IRS guidelines.

With certain restrictions, here are just a few (those taken directly from the IRS guidelines are in quotes):

“Site work includes curbing, paving, general site improvements, fencing, depreciable landscaping, roads, sewers, sidewalks, site drainage and all other site improvements, such as storm water retention basins, not directly related to the building.  See also Landscaping & Shrubbery.  For sanitary sewers, see Site Utilities.  Does not include land preparation costs, see also Site Preparation Grading & Excavation.” Bollards, roadbeds, culverts, bridges, paving, gates, concrete landscape islands, guardrails, permanently affixed displays. “Foundations or footings for signs, light poles, and other land improvements (except buildings). Includes excavation, backfill, formwork, reinforcement, concrete block, and pre-cast or cast-in-place work.” Sanitary sewer, irrigation systems. “Clearing, grading, excavating and removal costs directly associated with the construction of sidewalks, parking areas, roadways and other depreciable land improvements are part of the cost of construction of the improvements and depreciated over the life of the associated asset.” ” Freestanding enclosures for waste receptacles, typically constructed on a concrete pad with its posts set in the concrete.”

This one applies to golf course in particular, but illustrates what may apply to other real estate. “For example, a golf course has a 6-inch underlying drainage pipe that carries runoff to holding ponds. The removal of the drainage pipe would require a 12-inch wide ditch. The depreciable costs would be the land preparation costs of 12 inches of fairway surface times the length of pipe running through the fairway. If there were 30,000 feet of pipe being installed, 30,000 square feet of land preparation costs would be depreciable.”

For other classifications of real estate go to the above web site and search: Depreciable Land Improvements.

Next week I will describe a method I conceived, and had confirmed by a CPA in a national firm, where under certain conditions a buyer may depreciate a significant portion of the purchase price of large land parcels. The most aggressive taken by a client of mine was 60% of the $2,200,000 purchase price, in five years. Raw land – no buildings.

I have yet to meet an attorney or accountant who didn’t initially say, “It can’t be done.” When I suggest they research it, I soon hear them say, “By God – you can do it.”

When is the best time to buy?

I began my real estate career in late 1967. That winter I moved to northern Michigan when Bill Jennings, my broker, opened an office up there. Actually, it was temporarily in a chalet at Crystal Mountain Ski Lodge where Bill and I lived for three months. Bill was a wild Canadian who had once played professional hockey for the Detroit Red Wings, and lived like he was still on the ice. There was no end to his spending – but that’s another story. Suffice it to say I enjoyed myself immensely and lived through it.

It wasn’t all fun; we actually did work that winter, mainly listing real estate in preparation for the spring market.

One of my first appointments that spring was with four car company engineers who wanted to buy a hunt club. While showing them a property (they should have bought), one of the four said, “The time to buy was five years ago.”

My spirits dropped. It was just my luck to be getting into the real estate business five years too late.

Every year since then, someone has said to me, “The time to buy was five years ago.”

Right now the country is in one of the deepest recessions since The Great Depression of the 1930s. I grew up with parents who had lived through that depression and throughout my youth heard stories of how terrible it was. Then one day I was driving in my car, listening to an interview, when the guest said, “There were fortunes made during The Great Depression.”

My neck still hurts from snapping over to look at the radio. I actually said out loud, “WHAT”? Then the guest pointed out that there were still people with money and they were making great buys in real estate. That opened a whole new way of thinking for me. Ever since then when I hear how bad things are, the single word I think of is, “Opportunity.”

So what are you waiting for? There are great buys out there and the time to buy is now! Don’t wait until you, too, say, “The time to buy was five years ago.”

Back from the flu…

…and glad to be back.

Financing Commercial/Investment Real Estate

You hear everywhere that you “can’t buy or sell commercial/investment real estate because no one is lending money.” Well, that has some truth to it, but the fact is there is money available if you know where to look – and that is why you need a good commercial real estate advisor.

I was prompted to write this message because of how many times I have heard that said in the last year or two – coupled with how many times a day someone’s rate sheet for commercial loans comes across my desk. A good real estate advisor will have numerous sources to shop a loan for you, so all-cash sales are still viable.

Further, there are sources of financing that are not “traditional,” if you consider the boom of the last couple of decades “traditional.”

Today, buyers and sellers, mostly sellers, must look at their goals and then be prepared to do what it takes to meet them. As an example, it has been years since we have heard of “seller financing,” or “seller will assist with financing,” but we are hearing it more often in a week now than we heard it in a year in the past.

If a property owner wishes to retire, where else could they get the interest rate for their money than in a land contract or purchase money mortgage? And, that money is secured by something they believed in strongly – the real estate they owned.

If the time comes when they wish to liquidate that paper, there are buyers for it. Certainly the buyers will require a discount, but when you consider that the sale price was probably higher to begin with than could be obtained with a cash sale; and it will not be for the full sales price because the seller has already received some of it in cash, the discount will not be as deep as one might imagine.

Seller financing is just one of the “non-traditional” methods of selling. There are more. And for the buyers, the same holds true.

Real Estate Auctions: accelerated marketing

A compelling way to spotlight an asset or real estate portfolio is through the effective use of the auction process – more properly known as accelerated marketing. The title to a handbook could be “How to create a bidding war.”

Nationally, and internationally, auctions are a proven alternative to traditional real estate brokerage. In some countries it is the only method used.

According to the Indiana-based consulting company The Gwent Group, the auction method accounted for nearly $59 billion of U.S. real estate sales in 2002 and over $60 billion by 2004. A few years ago the National Association of REALTORS® (NAR) estimated that by 2010 one in every three U.S. real estate transactions will occur using the auction method. I am not so sure about that, but for many reasons I see strong growth in the auction method of selling real estate.

With accelerated marketing, traditional pricing paradigms are replaced by aggressive marketing. The resulting competition creates an excellent forum to realize a property’s true market value.

Auction Benefits for Property Owners

• The seller dictates the terms of the transaction.
• Quickly close transactions and gain liquidity
• Property is sold as-is.
• Sale is made without contingencies.
• Sale is consummated on a specific date
• Viewing time is limited/controlled by the seller

What about buyers?

The auction method attracts smart cash buyers and accelerates the process of selling any property or asset by compressing the marketing period. No other sales method accomplishes that. Offers and counter-offers, as well as frustrating, slow negotiations, with buyer’s remorse setting in are replaced by aggressive bidding among serious prospective buyers.

Additional considerations:

• Choose from several auction formats.
• Appropriate for all types of property-commercial, industrial, office, residential, or vacant land
• Especially effective for “trophy” and hard to price properties

If you have a relationship with another broker, we can still work together.

Learn More:
To learn more about accelerated marketing please contact me at (800)345-6694 or gary.lillie@svn.com.

SUPPLY CHAIN MANAGEMENT: what factors affect your real estate investment?

Supply Chain Management is the art and science of getting product from one spot to another in as efficient a manner as possible.

Direct cost is one of the obvious concerns in the supply chain, but indirect costs resulting from delays in delivery, lost production and late distribution can be just as important – even more so. Not getting a product to the user in a timely manner may not just cost the user money; it may lose a customer.

But what has that to do with real estate?

Real estate investors often have the opportunity to buy a NNN-leased distribution center. They are probably a good investment, but before committing the investor should drill deeper than the user’s credit rating and the numbers on the spread sheet. Other questions are in order before signing that letter of intent.

What is the long-range strategy of the tenant? Will outside forces such as oil prices cause them to switch from a few big distribution centers to a number of smaller ones – or vice versa? Have they recently had a change of management, which may bring about a change in strategy? What industry or customer base do they serve and how might that drive change? If methods of distribution change how will this building fare; e.g. does it have rail siding or adjoin an airport?

The supply chain accounts for much of a company’s carbon footprint; will the move to “green” affect the business of moving supplies?

Might politics – both foreign and domestic – terrorism, human rights, and environmental demands influence a shift back to local, versus off-shore suppliers?

Changes may be driven by negative influences such as higher fuel costs, or positive influences such as improved technology; but you can and should plan on change. Moving supplies in the future may be as relative to the way they are moved today, as today’s methods are to the way it was done in the 1960s.

So ask questions when considering that distribution center. It is probably a sound investment, but due diligence greater than traditional economic analysis is in order.

OPPORTUNITY: Is it out there?

My parents came of age during the Great Depression so as I grew up I heard stories from them, at school, in movies and everywhere else about how bad it was. In fact, my parents had to keep their marriage a secret because my dad was a coal miner and my mother worked in the company store. Back then there was a rule of just one job to a family. Had it been known they were married my mother would have had to quit her job.

Things were tough-to-worse everywhere. So imagine my shock when one day while driving my car and listening to an interview, the guest said, “Many people made fortunes during the depression.”

My head snapped to the radio so fast my neck got a crick in it. I said out loud, “What?”

The guest went on to discuss how many people with money amassed fortunes by acquiring good properties at bargain prices. Assets were up for grabs due to the owners bad planning, bad management, bad luck, or a combination of all of the above.

I don’t suggest opportunism in the sense of preying on people; in the past I have rejected offers from people who wished to partner with me in buying tax-sale property. I personally will not benefit from the bad fortune of others. However, there are many opportunities that offer win/win scenarios.

In my own commercial real estate business, as an example, I have listed a farm strategically located within a hundred yards or so of an I-94 exit. It once had a $6 million sales contract on it, but when the downturn came the national builder terminated the contract. Today, because of cash needs of the seller the farm can be bought for the list price of $2.6 million – with terms.

Sometime in the not too distant future that farm will be developed into a successful residential subdivision.

When I listed the farm I called the vice president of the developer/builder that had walked away from the contract to see if they would like to pick it up again at the new price. His answer was “No.” He went on to tell me they were still disposing of land – that he had just sold a completely developed 203-lot subdivision in which they had invested about $68,000 per lot…for $3,000 per lot!

The message is there are many opportunities in today’s market. The old adage of “buy low and sell high” holds true now more than ever. And, it’s not just in land where the opportunities lie; it is in every classification of property that exists. People find themselves in need of cash and must dispose of assets.

The time to buy low is now.

9/11

We will never forget – and we thank those who protect us; our military, police, firefighters, EMS, and all of the rest. Be safe.

IT’S JUST A LEASE? Get expert advice

Legal:

There is (almost) no such thing as a pro-tenant lease; there are pro-landlord leases and fair leases, but rarely a pro-tenant lease.

Tenants should try to negotiate a gross lease; and they must understand what their responsibilities will be over and above the rent.

If the tenant reimburses the landlord for taxes, what happens if the building is sold and taxes double – or worse?  That can cause even a long-established business to fail; especially during a recession.

If the tenant pays for maintenance, are the words “capital improvements” in their. That could include a new furnace or roof.  With a 5 year lease and no options to renew that is probably not equitable.

Are there charges for common area maintenance, such as snow plowing?  What about management fees?  Ask to look at historical charges (or projections if there is no history), and negotiate a “not to exceed” amount.

The tenant wants the right to assign the lease and/or change the use, so that they can sell their business and/or find their own substitute tenant if the business does not do well.  Try to negotiate in advance the right to terminate a lease early by paying a lease termination fee, perhaps equal to 4 to 6 months rent.

Tenants should also ask for options to extend the lease term at a predetermined rate and conditions. Otherwise the landlord or new owner may try to extort exorbitant rent or conditions when the time comes to renew (just this morning a friend told me of such a case with his son). Pay the new rate or move your business.  If you move, the Landlord may open a competing business or lease to a competitor at a premium; taking advantage of the good will created by the tenant.

Is their a first right of refusal in the event the landlord decides to sell?

If the tenant is a business entity try to avoid personal responsibility, or to limit personal responsibility if a personal guaranty is required.

The opposite of the above may be the goal of the landlord; except the landlord should not ordinarily want to drive the tenant out of business. The landlord’s goal should be to keep a responsible tenant financially healthy so cash flow continues.

Insurance:

These are things to discuss with your insurance agent:

A LANDLORD should include an Indemnification agreement from the tenant, and a certificate of insurance naming landlord as additional insured; in limits that are reasonable and prudent to exposures unique to the risk. In other words, are you insuring a retail store in downtown Manhattan, or a in small strip mall in Washekaw, Minnesota? Reasonable and prudent dollar amounts will change dramatically in those examples.

Require renter’s insurance and liability on a blanket basis. Essentially you may have problems with tenants who are not covered by their own insurance. If a renter does not have tenant’s insurance it may affect your own insurance rates.

What limitations are in your own policy for a vacant building or unit? Are you covered if it is vacant for one week, one month, three months? You may need a rider to cover vacancies, but not just vacancies – talk to your insurance agent.

TENANTS: As a renter in an office building, what is your coverage if you or even another tenant accidentally damages or destroys the building? Are you covered for interruption of business (loss of income), cost of recreating your records, or expediting expenses allowing you to get back in business as soon as possible? Even residential tenants with home offices may need additional coverage.

New construction? That’s a whole different issue.

A book could be written on the subject of insurance coverage and language in a lease, but what it boils down to is be sure your insurance agent is in the loop prior to signing that lease.

The most important point to remember about a lease is they are not generic. As a long-term broker I know that leases seem to vary in correlation to how many landlords and how many tenants there are out there.