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Cost
Segregation - A Value Added Service
Are you paying too much in taxes? Few corporate property owners are taking advantage of the new tax laws issued by the Internal Revenue Service regarding cost segregation. In today's economy, maximizing cash flow has become a top priority and can be done by performing cost segregation analyses. If you are thinking of expanding or relocating your corporation by way of acquiring new property, having a cost segregation study performed may be a pivotal point in your corporate planning. A corporate property owner who has constructed, is going to acquire, or has acquired property since January 1, 1987, and who also has a tax basis in the property and anticipates paying federal income taxes in the near future, is a prime candidate for a cost segregation study. The savings in the first year alone can offset a portion of the costs associated with the relocation or expansion. Cost segregation is the process of identifying and segregating building costs into real property, land improvements, and personal property, and depreciating them over a shorter time period for a quicker write-off. While cost segregation has been around since 1962, recent changes to tax laws and rulings to stimulate the economy have increased the popularity and awareness of cost segregation. For income tax depreciation purposes, there are two major types of assets: Section 1250 real property and Section 1245 personal property. More specifically, by taking advantage of certain rules in the tax law, property may be further segregated within these two sections by identifying five-year and seven-year personal property, and 15-year and 39-year non-residential real property. Two of the most recent IRS rules that allow for additional benefits are Revenue Procedure 2004-11 and Bonus Depreciation, which resulted from the Jobs and Growth Tax Relief Reconciliation Act of 2003. Revenue Procedure 2004-11 allows property owners to retroactively catch-up on missed depreciation on assets owned as far back as 1987 with a one-year catch-up adjustment called a Section 481(a) adjustment. This creates a large tax deduction and generates additional cash-flow from tax savings in the year the tax return is filed and the cost segregation study is performed. It also allows taxpayers to file for a change in accounting method and depreciation for property they no longer own as long as they do it within a three-year period. Bonus depreciation allows real estate owners to take an additional 30% or 50% deduction (depending upon when the asset was placed in service) in the first year for newly constructed assets with less than a 20-year life or qualified leasehold improvements with a life of more than 20 years on a three-year-old building. In addition to depreciation and retroactive analyses, there are other uses for cost segregation studies in real estate. Purchase price allocations, under new accounting rules (Financial Accounting Standards Board Statement No. 141), require the allocation of the purchase price paid by determining the fair market value of the underlying tangible and intangible assets. A component of this evaluation includes determining the depreciated replacement cost of the core and shell of the property (a natural derivative of the cost segregation study). State Investment Tax Credits are credits to taxpayers for constructing projects in their territory and may be analyzed for proper depreciable lives and proper allocation for tax credit purposes. Other derivatives of cost segregation studies include long-range capital expenditures, budgeting and insurable replacement cost analysis. The IRS has supported the process of properly identifying these assets through engineering-based studies using engineering-based analysis techniques. In order to maximize savings, it is more beneficial to utilize engineering-based expertise to uncover not only the more apparent personal property assets, but also the items behind the walls that are a part of the assets classified as personal property. The process of segregating costs can be achieved by utilizing independent qualified professionals who rely on either actual costs or industry accepted methods recognized in IRS rulings to review and identify costs from detailed construction records. With the assistance of a tax expert, an overall review of these costs for proper classification is also performed. Without a formal study, evidence by an independent report, property owners may subject themselves and investors, if applicable, to IRS scrutiny. For example, the following items would appear to be structural in nature: specialty lighting, supplemental HVAC, wiring for computer equipment, receptacles, and chemical sprinkler systems dedicated to equipment, and supplemental plumbing. However, a significant portion of these items service dedicated components in buildings and can qualify for accelerated depreciation. Additional benefits of cost segregation occur in situations where the client is involved in new construction, leasehold improvements, renovation, rehabilitation of certified historic structures, and the purchase of existing buildings. For example, a typical office building purchased in 1998 with a capitalized cost of $10 million with $2 million reclassified into shorter lives, results in approximately a $1 million adjustment in the current year with a $500,000 tax benefit assuming a 40% tax rate. A 2004 acquisition of a shopping center with a capitalized cost of $150 million with $32 million classified into shorter lives results in approximately a $1 million tax benefit in the first year assuming a 40% tax rate and that the property didn't have any prior asset classifications. A newly constructed hotel with capitalized costs of $25 million and $7 million classified into shorter lives, with an additional bonus depreciation benefit of $3 million, results in approximately $4.5 million in tax savings over the first five years assuming a 40% tax rate. The benefits reaped from a cost segregation study outweigh the cost for the study itself many times over. On average, the cost of a study could be $12,000 to $25,000 depending on the circumstances surrounding the owner's tax situation, such as the size of the property and the availability of data. With such a big savings, one might also question what the potential exposure to the IRS is? Having a cost segregation study performed by an independent qualified professional with experience doesn't typically increase the chances of an audit. It is important to keep in mind that tax deductions based on accelerated depreciation are merely a timing issue. If a cost segregation study wasn't performed, the owner would still be depreciating the assets, but at a slower pace. Corporate property owners focus on reducing costs and increasing cash flow. By taking advantage of cost segregation studies, the recent IRS rulings, and legislation geared toward helping corporate property owners reduce taxable income, many owners can achieve their financial goals. John J. Luongo, CPA, is a principal and Nicole A. Swasey, ASA, is a manager in the Cost Segregation group
of Schonbraun Safris
McCann Bekritsky & Co., LLC, a national real
estate consulting and accounting firm headquartered in |