Attention Apartment Owners: Find incredible cash flow and tax benefits through Cost Segregation

Author: Gian Pazzia
Publication: Apartment Age Magazine
Publication Date: January 2004

What Is Cost Segregation?
Cost Segregation is a strategic tax savings tool that allows companies and individuals, who have constructed, purchased, expanded, or remodeled (landlord or tenant improvements) any kind of real estate to increase cash flow by accelerating depreciation deductions and deferring income taxes.

When segregating the costs of a construction project, it is easy to properly identify costs of equipment, furniture and fixtures, and computer equipment that can be depreciated over 5 and 7 years for tax purposes. However, the construction-related costs, which may account for as much as 75 to 90 percent of the overall project cost, are usually lumped together as real property with a depreciable life of 27 ½ or 39 years.

The primary goal of a cost segregation study is to identify all construction-related costs that qualify for shorter depreciable lives. Reducing tax lives from 27 ½ or 39 years (straight-line) to 5, 7 and 15 years (using accelerated methods) results in an acceleration of depreciation deductions, a reduction in tax liability and increased cash flow.

History
As far back as 1959, the courts ruled (and the IRS subsequently agreed) on the validity of segregating costs for tax depreciation on buildings (Shainberg v. Commissioner, 33 TC 241, IRS C.B. 1960-1). In 1977, Revenue Ruling 77-55 required that the allocation of costs to `structural components’ be based on Internal Revenue regulations relating to Investment Tax Credits (Treas. Reg. 1.48(c)(1)). Since Investment Tax Credits were only allowed on personal property used in a trade or business, this ruling helped establish the foundation for distinguishing between personal property and real property for tax depreciation.

As a result of over 200 court cases and supporting rulings, the benefits of Cost Segregation has emerged as a major tax-planning tool. In the landmark Hospital Corporation of America case (1997), the courts further expanded the benefits of Cost Segregation by ruling certain costs related to the operation of a specific piece of equipment (that would otherwise be viewed as structural such as electrical and plumbing costs) qualified to be depreciated over the life of the underlining asset (the equipment) provided that neither was required for the normal operation and maintenance of the building.

When Should The Study Be Done?
The ideal time to begin a Cost Segregation Study is when plans are drafted to construct, expand or remodel a structure or when purchasing an existing building. However, a study can be completed anytime thereafter. In fact, current Internal Revenue Service procedures make it easy to go back and claim accelerated depreciation on assets acquired as far back as 1987, without amending prior tax returns.

Our Engineering Approach

· Review project drawings and specifications to identify all building components (existing structure) and construction-related assets (new construction) that qualify for accelerated depreciation deductions.

· Obtain and review copies of approved contractor pay requests, change orders, and miscellaneous invoices in order to segregate these costs properly into the correct asset classifications for federal income tax purposes.

· Develop and provide a listing of construction costs for which a specific breakdown is required from the contractors involved. If the contractors are not able to provide this information, we will estimate the costs of the assets by using nationally recognized cost estimating methods.

· Allocate project indirect costs, such as contractors’ general conditions, architectural and engineering fees, permits, etc., to all project-related assets on a functional basis.

· Visit the facility to ensure that all qualifying personal property and land improvement assets have been identified.

· Prepare a fully documented report that includes project background information, methodology, fixed asset classifications and descriptions. The report will also include an allocation of project related fees and services and fixed asset classification spreadsheets segregating the assets into personal property (5 or 7-year tax life), land improvement property (15-year tax life) and residential or commercial real property (27.5 or 39-year tax life). In addition, the report will include references to court cases, revenue rulings, tax citations and photographs supporting the position taken regarding the identification of personal property and land improvement assets for federal income tax purposes.

What Kind Of Projects Qualify?
Any structure used in a business environment is eligible for the benefits of Cost Segregation. Based on our experience, percentages of project-related construction costs that could be reclassified from either 27.5/39-year real property to either 15-year land improvements or, 5 or 7-year personal property vary from 10% to 90%.

Examples of projects benefiting from Cost Segregation are Restaurants, Apartment buildings, Hotels, Manufacturing facilities, Retail stores, Office buildings, Wineries, Grocery stores, Shopping malls, Airports, Sports facilities, Golf courses and ranges, Resorts, Healthcare facilities and Medical centers, Industrial buildings, Distribution centers, Auto dealerships, Auto service centers and more.

Benefits Of A Cost Segregation Study

· Increased current cash flow through accelerated tax depreciation.

· Net present value savings on tax depreciation.

· Independent third-party analysis that will withstand Internal Revenue Service scrutiny.

The best way to illustrate the direct financial benefits is the following example:

An individual purchased a 27-unit apartment building in 1994 for $1,004,066. His tax return showed the amount allocated to the building as $793,212; the balance of $210,854 to the land. The return showed the entire $793,212 was being depreciated straight line over 27 and one-half years. In 2001 we performed a Cost Segregation Study and the results showed a total of $478,250 re-allocated to five and fifteen year property with accelerated depreciation. Assuming a combined net tax rate of 45% and an expected 8% rate of return, this owner was able to save a total of $132,030 in tax on his 2001 tax returns for a building he purchased in 1994! Also, no amended returns were necessary.

The potential benefits derived from a Cost Segregation Study could be significant whether a company is adding a $500,000 expansion or building a new $40 million hotel. Cost Segregation is not a way of avoiding taxes but rather a way of deferring taxes. “A dollar earned today is better than a dollar earned tomorrow”.