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The Cash Benefits of Cost Segregation
This valuable tax strategy results in improved cash flow
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Cost segregation is a valuable tax strategy. It views depreciable real estate property (used in a trade or business, or held for investment) not just as a building and land, but also as land improvements and elements of personal property. The tax advantages and related tax savings come from accelerated depreciation deductions that generate a cash-flow benefit, and improved cash flow means cash in your pocket.
A Little History. Prior to 1981, taxpayers were allowed to break their real estate into components of depreciable assets to qualify for a credit known as the "investment tax credit." The Internal Revenue Service defined personal property for purposes of this credit in Internal Revenue Code (IRC) Section 38. It was a common event to have a "componentization study" completed to identify the personal property that was attached to or built into a depreciable building. A side benefit to the study was that you could depreciate the identified personal property over a much shorter life than was allowable for a building.
Nothing good ever lasts forever; with the passage of the Economic Recovery Tax Act (ERTA) in 1981, the use of component depreciation was repealed. A few years later, in 1984, the investment tax credit was also repealed; however, a very significant item was left in the IRC - IRC Section 38 - that defined personal property. The loss of component depreciation was not a significant loss at the time because the ERTA also enacted the accelerated cost-recovery system (ACRS), which allowed you to depreciate buildings over a 15-year life.
The 15-year life did not last long, however. The Tax Reform Act of 1986 increased the depreciable life of real estate to 31.5 years for nonresidential property and 27.5 years for residential property. Currently, the depreciable life for nonresidential property is 39 years. The result of these changes is that real estate owners are locked into a long depreciable life that is not economically realistic without the benefit of componentization.
The introduction of ACRS and modified accelerated cost recovery system (MACRS), its successor, eliminated the component method of depreciation, but not the segregating of costs. Remember IRC Section 38?
1997 produced one of the most significant tax cases relative to depreciation ever decided. In Hospital Corp. of America (HCA) v. Commissioner, 109 TC 21 (1997), the tax court ruled that IRC Section 38 could be relied upon to identify personal property associated with a building and its associated land improvements. The court found that the definitions of personal property allowed HCA to use a segregation technique that resulted in many parts of its hospitals being classed as personal property with shorter lives.
In decision 1999-008, the IRS reluctantly agreed that cost segregation does not constitute component depreciation. Thus, the IRS has accepted cost segregation as a qualified method of allocating costs to personal property; however, in Chief Counsel Advice Memorandum 199921045, the IRS states in part that an "accurate cost-segregation study may not be based on noncontemporaneous records, reconstructed data, or taxpayer's estimates or assumptions that have no supporting records."
Segregating Costs. Cost-segregation studies make it possible to identify assets installed in a building and to reclassify the allocated costs from real estate to personal property. This personal property can then be depreciated over lives ranging from 3 to 20 years. The most common lives of personal property within a building are 5, 7, or 15 years.
The resulting savings can be significant. To illustrate, for each $100,000 in assets that can be reclassified from a 39- year recovery period to a 5-year recovery period, a $16,000 net-present-value savings will result, (assuming a 5-percent discount rate and a 35-percent marginal tax rate).
A cost-segregation study will segregate costs of real estate into four basic categories: personal property, land improvements, building, and land.
Personal property is typically depreciated over a 5- or 7-year recovery period. In addition to a shorter life, personal property is depreciated using the double-declining balance method. This category generates the most dynamic tax benefits. This category includes furniture, carpet, fixtures, window treatments, and equipment. Land improvements include sidewalks, paving, fences, and landscaping. This category is depreciated over a 15-year recovery period on the 150-percent declining- balance method. A significant benefit can be derived from this category as well. Although the most significant benefit of a cost-segregation study is maximizing the costs allocated to personal property and land improvements, there are also benefits to segregating the costs associated with the building category. All costs associated with the building structure will be depreciated over a 27.5- or 39-year recovery period for residential and nonresidential property, respectively, using the straight-line method. If the building costs are segregated into building components, however, and if one of the components is later replaced, the unrecovered costs would then be fully deductible. The most classic example is roofing. Roofing must be depreciated over the appropriate building life of 27.5 years or 39 years, although everyone knows that roofs don't last much over 10 years. If the cost of the roof is segregated from the rest of the building, the undepreciated balance can be deducted in the year that the roof is replaced. This would not happen if the building costs were lumped together.
Cost Segregation Requires a Quality Study and Report. The key to a cost- segregation study is that professionals must conduct it with expertise in tax regulation, building, and engineering. This typically requires a team of certified public accountants and engineers to produce a report that will withstand the scrutiny of the IRS. The good news is that there is solid guidance compiled from court decisions, IRS revenue procedures, and IRS audit manuals that can be relied upon to produce a quality report.
The IRS issued its Cost Segregation Audit Techniques Guide in 2004, which provides an extensive outline of the necessary components of a quality cost- segregation study and accompanying report.
Timing. A cost-segregation study can be used for buildings being constructed or recently purchased, or buildings already in service. It is worth considering a cost- segregation study of any building that was placed in service after 1986. One of the best ways to know if a study would be a value is to request use to calculate an estimated tax and cash benefit for a specific property. For buildings already in service, there is a catch-up provision that could make it very attractive to do a study.Basically, any amount that could have been deducted previously can be deducted in the current period. This can be a tremendous benefit if a building was placed into service between 2001 and 2003 because the personal property may also qualify for a 30- or 50-percent bonus depreciation deduction.
Change of Accounting Method (the Catch-Up Provision). When a cost- segregation study is completed for a building that is already in service, it will result in finding depreciation deductions that could have been deducted over the time now lapsed. Accelerating these deductions is a very attractive reason to conduct a study. The difference between what was deducted and what could have been deducted is known as an IRC Section 481(a) adjustment. The good news about these adjustments is that, pursuant to Internal Revenue Service Ruling 2002-19, the whole difference is deductible in the year that the study is performed, provided that Form 3115 is filed for that year.
Form 3115 is an application for changing your method of accounting - in this case, a change in how depreciation is computed. Internal Revenue Service Ruling 2002-19 makes the application of change in accounting method for depreciation purposes an automatic election.
For example, if a typical office building was purchased although all these items are helpful, a study can still be performed even if some are not available. The professional will also ask questions about the property and what specialty items they should look at.
Site visit. The cost-segregation professional will visit the property. This visit is conducted to verify what items are actually at the site, perform takeoff counts, take measurements, and take pictures for documentation.
Costing. The IRS lists six costing methods used in preparing cost-segregation studies in its Audit Techniques Guide; however, only two methods will be discussed here, as they are the most accurate and common (a detailed engineering approach from actual cost records and a detailed engineering cost-estimate approach). The detailed engineering approach from actual cost records is the best way to perform a study because it relies on the actual costs and contractor records. This method is most commonly used with new construction since the cost records are more readily available. A cost-segregation professional uses the actual cost records to determine item costs.
The detailed engineering cost-estimate approach is used when actual costs are not available. In this approach, the cost segregation professionals estimate costs by using valuation services such as RS Means or the Marshall Valuation Service. In many situations, both approaches are utilized. This happens because some detailed costs are readily available and others are not and must be estimated. The key to using both methods is providing proper documentation and substantiation for the costs of the reclassified assets.
Classification. All property costs in a cost-segregation study are classified into four basic categories: personal property, land improvements, building, and land, as mentioned earlier in this article.
The report. Once the interview, site visit, costing, and classification are complete, the report is issued. A quality report, as defined by the IRS, includes an executive summary, asset schedules, costing data, certification, and legal citations and exhibits.
Other Benefits of Segregating Costs. There are many other advantages to a cost- segregation study in addition to the immediate tax savings and cash-flow increase. Two potential side benefits to cost-segregation studies are insurance cost savings and estate planning advantages.
By providing a cost-segregation report to your insurance underwriter, the insurance company can better understand and focus on its risk, and more accurately underwrite the insurance cost. This potential insurance cost savings result in more money in your pocket.
Using a cost-segregation study in the estate planning process can create the opportunity to accelerate the depreciation on the same property at its original cost and then again at its stepped-up basis.
A cost-segregation study provides significant benefits for most commercial real estate owners. Accelerating the depreciation will allow current tax savings to be maximized and cash flows to be significantly increased, translating into more cash in your pocket, which is something that all of us desire.