Expert View
Release the
cash in your property by applying cost-segregation techniques
Using your commercial real estate assets to put money in your
pocket
by Annette Bajek
If your clients own
commercial or residential rental property and dutifully deduct 1/39th or
1/27.5th of its value each year, they are leaving money on the table. The
39-year figure represents the depreciable life of a commercial building while
25.5 years represents the depreciable life of a residential property.
While the entire value
of the property or leasehold improvement is recovered during the 39- or
27.5-year span, the IRS allows components of the costs to be recovered much
quicker, over five, seven or 15 years. This means more money in your client's
pockets immediately, not later.
Ask the client if they
would rather recover the costs today or wait 39 years. Approximately 20 percent
to 30 percent of a building's components can be reclassified into shorter-life
property and the corresponding costs recovered that much sooner. For every
dollar a cost segregation specialist moves from a 39-year property to a
five-year property, the total net present value benefit equates to
approximately 22 cents. Any structure used in a business environment is
eligible for the benefits of cost segregation.
If you are a CPA, or
an attorney who has real estate clients, and haven't heard the term 'cost
segregation' yet, you will undoubtedly hear more about it in the near future.
Since the IRS released its 121-page Cost Segregation Audit Techniques Guide
last September, the buzz about the topic has never been greater.
Even though cost
segregation has been around for more than 20 years, it is only now finally
becoming mainstream. In 1986, Congress abolished the Investment Tax Credit and
stretched the depreciable lives of buildings from 19 to 31.5 years, and now to
39 years - 27.5-years for residential property. Taxpayers saw their normal
deductions on property reduced significantly. It was around that time the Big
Eight accounting firms began to pioneer cost segregation in its current form
and started recommending it to their larger clients. The idea was simple: All
buildings contain components and fixtures necessary for taxpayers to run their
businesses. These items are not necessary for the ordinary operation and
maintenance of a building and should not be considered 'structural components'
of the building. Conversely, they are defined as tangible personal property or
land improvements. Even though the IRS did not allow component-depreciation
under MACRS (the Modified Accelerated Cost Recovery System), the Tax Court
ruled in 1999 that items in a building that qualify as tangible personal
property under the former ITC rules may be separately depreciated under MACRS
as personal property.
So how does all of
this translate into dollars?
Consider the following
example. A taxpayer constructs an apartment building for $2.1 million and
places it in service in the same year. The client's CPA identifies that
$100,000 is for furniture and equipment such as stoves, dishwashers and other
appliances. The remaining $2 million of project costs are treated as 27.5-year
property until a cost segregation study is performed. The cost segregation
specialist finds that an additional 16 percent of the construction-related
costs should have been reclassified to a five-year life and 9 percent of the
cost to a 15-year life. Further assume a combined 41 percent federal and state
tax rate.
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. The benefits
of a study are magnified even more if it falls within the bonus depreciation
time period.
It gets better. Let's
assume that your client purchased that building within the last 18 years, and
has been depreciating the building with the traditional straight-line approach.
What happens to the 16
percent to 25 percent of the property that should have been fully depreciated
at this point? Surprisingly, your client can recover in one year. The IRS
allows an automatic change in depreciation (IRS Form 3115). Take the
depreciation - all of it - in one year. Write it off against this year's
income. Pay fewer dollars in income tax, without amending past returns.
Typically, cost
segregation clients achieve a return on investment of 20 to 1. Each building
and every study is different. Different types of buildings require a more
detailed analysis, such as hospital vs. warehouse, and different information is
available from each company. These factors figure into the cost of the
engineer's time to complete the study. A good cost segregation firm will give
you and your client a complete fee proposal, including estimated tax savings,
so that you and your client can determine how the benefits outweigh the costs
for your specific situation.
For many taxpayers
that own commercial real estate, cost segregation is a slam dunk. It offers an
easy, turnkey opportunity to significantly reduce taxable income. Today, more
attorneys and CPAs are recommending the service to their clients.