Bottom Line: Asset Management
Tax-saving trick: Cost
segregation studies allow owners to pocket more cash
IRS issues guidelines for a qualified
study.
By Nicole Crate, ASA
APARTMENT
FINANCE TODAY • JUNE 2006
Whether they
choose to buy and hold properties or do renovations or new construction,
multifamily owners and developers who retain ownership can benefit from a
little-known secret and immediate tax savings, sometimes amounting to
millions of dollars, by conducting a cost segregation study.
The time for
a property owner to think about having a cost segregation study performed is
at the point of purchase or during the early stages of construction. Taking
the time to identify an opportunity will allow an owner to reap the benefits
right away and smooths out the cost segregation
process – benefiting the owner and the cost segregation specialist performing
the study.
A cost
segregation study is an engineering-based tax analysis that allows real
estate owners to accelerate the depreciation of property assets, thereby
reducing their federally taxable income. It can also be used for financial
accounting, insurance and property tax purposes.
For income
tax depreciation purposes, there are two major types of assets: Sec. 1250
real property and Sec. 1245 personal property. 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, 15-year
land improvements, and 27.5-year residential and 39-year nonresidential real
property.
For example,
the following items would appear to be structural in nature: specialty
lighting, supplemental HVAC, wiring for computer equipment, receptacles,
kitchen appliances, 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 upon further inspection.
Multifamily
properties suitable for cost segregation include:
- High-value properties such as
seniors housing, garden apartment communities, luxury apartment
communities, mixed-use with retail, mixed-use with office, college
housing and high-rise communities in excess of $1 million. These can
generate sizable savings from a study.
- Any property purchased for
full basis (i.e., cash plus assumption of debt).
- Any development property.
- Any property acquired in a
tax-free exchange (i.e., a Sec. 1031 exchange), provided the asset has
substantial tax basis. Cost segregation studies can help identify the
real and personal property basis in the new “like-kind” property that is
exchanged for the existing property to help avoid the possibility of
paying taxes on any excess property above the adjusted basis.
- Assets owned since 1987:
Internal Revenue Service (IRS) 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 Sec.
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.
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 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).
Bonus
depreciation, resulting from the Jobs and Growth Tax Relief Reconciliation
Act of 2003, allows real estate owners to take an additional 30 percent or 50
percent 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. Property qualifying for bonus depreciation must have
been placed in service before May 6, 2005.
Private
owners and developers receive immediate cash flow benefits through additional
depreciation. There is virtually no reason why they would not want to have a
cost segregation study performed. Real estate investment trusts (REITs) also stand to gain from cost segregation studies
in one of two ways: First, they can significantly reduce their taxable income
and its distribution requirement, thereby retaining additional cash flow.
Second, a cost segregation study permits a REIT to pay dividends in the form
of return of capital (untaxed until shareholders’ shares are sold) instead of
ordinary income if it chooses not to alter its distribution policy.
While many
opportunity funds do not take advantage of cost segregation studies because
they have plans to dispose of their assets in the near term or because they
are owned by pension funds that will not benefit from the additional
depreciation, the time value of money realized through a cost segregation
study may still ultimately present some financial gain.
How does a
cost segregation study work?
Cost
segregation studies for existing properties can have a turnaround time of
four to six weeks, depending on the size and complexity of the project. Newly
constructed properties can start in the developmental stage on through to
completion of construction and can last from one to two years.
The studies
typically include, but are not limited to, the following:
- A site visit to verify the
condition, functionality and existence of assets.
- Copies of as-built drawings,
including a site survey with a legal description.
- A review of property-condition
reports, purchase agreements and appraisals, which are used to
corroborate evidence when original construction documents are not
available.
- General contractor and
subcontractor payment applications, generally referred to as AIA
(American Institute of Architects) documents, as well as owner invoices
for work performed or items purchased outside the contractor’s scope.
- Depreciation schedules for
property treatment verification on projects eligible for a Sec. 481(a)
adjustment.
- Interviews with contractors,
property managers, and building engineers to ascertain specific uses of
property.
Upon
completion of a thorough review of gathered data, functional and permanency
tests, engineering quantity “take-offs” are conducted to determine assets
that qualify as real and/or personal property as defined by the IRS. Quality
deliverables include proper verbiage and references as dictated by the IRS
Guide to Cost Segregation Techniques.
What do you gain?
Let’s say
that an owner purchased a 200,000-square-foot garden style apartment complex
for $10 million in June 2005; the property has 300 units. A cost segregation
study conducted in the year of purchase revealed $2.1 million of costs
segregated into shorter tax lives (five-, seven- and 15-year property) and an
increase of $1.2 million of depreciation in the first five years. For this
study, five-year assets include items such as carpeting, laundry equipment
and dedicated plumbing for laundry and dishwashers. Seven-year assets include
furniture and fixtures in the management office, and 15-year assets include
landscaping, paving, sidewalks and curbing, to name a few.
Assuming a 7%
discount rate and 40% tax rate, the owner of this property would receive a
net present value tax savings of $100,000 in the first year and $400,000 over
the first five years based on the segregation of assets into shorter
depreciation periods. The first-year net present value savings more than pays
for the study, which can range from $12,000 to $14,000 for a facility of this
size.
Multifamily
owners and developers typically focus on cash flow,
value and return on investment, but many are unaware of the opportunity to
realize immediate tax savings with the help of a cost segregation study. By
reducing taxable income and increasing cash flow, owners can leverage a
qualified cost segregation study as a significant financial management tool
that plays a key part in their tax, accounting and insurance planning.
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