by
Garry E. Adams What would you say
if someone offered you a dollar in exchange for a dime? To
skeptics, that would sound too good to be true. Yet some
Cost Segregation firms provide a service that can help
clients to return as much as one dollar in tax savings for
every ten cents spent on the service. This service, known as
cost segregation, brings significant tax savings, recognized
by the Internal Revenue Service (IRS), to building owners
interested in retaining cash. Cost
Segregation: Why Your Clients Can Benefit From a
Comprehensive Study Do you have clients
who have constructed, purchased, expanded or remodeled any
kind of commercial real estate? If so, cost segregation is a
strategic tax deferral tool that allows companies and
individuals to increase cash flow by accelerating
depreciation deductions on their properties and deferring
income taxes. How Cost
Segregation Works A cost segregation
study is an engineering process, accepted by the IRS, that
identifies building costs and land improvements that
traditionally are depreciated over long periods (27.5 to 39
years). The study is the vehicle to re-allocate a
significant portion of these costs to asset classes with
shorter lives. This results in accelerated depreciation and
increased cash flow. What qualifies
for a Cost Segregation Study? Nearly any type of
commercial property can benefit from a cost segregation
study, including (but not limited to) office buildings,
industrial/manufacturing facilities, retail centers, single
tenant retail, hotels and apartment buildings. As a general
rule, anyone who has purchased or constructed a commercial
property since Jan. 1, 1987, with a depreciable basis in
excess of $800,000, or who has made interior improvements of
$450,000 or more, will likely benefit from having a cost
segregation study preformed. Because of
depreciation recapture, cost segregation is generally not
cost effective for taxpayers who plan on holding the
property for three years or less. However, taxpayers who
have the right type of exchange strategy in place can
utilize this to defer any depreciation recapture, along with
any gains, as long as they perform a cost segregation study
on the replacement property. Since cost
segregation helps those with taxable income, timing is
important. If clients are in a situation where they can make
use of additional deductions, cost segregation studies
should be employed as soon as possible to take advantage of
the time value of money. However, clients who never utilized
cost segregation in the past, since their property was not
generating enough income at the time, can have the study
performed and retroactively correct the depreciation as if
they had previously completed the study. This is allowed via
Revenue Procedure 2002-19. By performing this
“look-back” cost segregation study, all missed
depreciation deductions from prior years can be used to
offset income in the current tax year through the filing of
Form 3115 – Application for Change in Accounting
Method. All this without having to file an amended
return! What Are The
Methodologies Used in Preparing a Study? A successful cost
segregation study comprises elements of the engineering,
architectural, accounting and tax disciplines. The IRS
prefers the more accurate use of an engineering-based
approach in identifying and reclassifying construction costs
into applicable segregated categories. According to the
IRS Cost Segregation Audit Techniques Guide, preparation of
cost segregation studies requires knowledge of both the
construction process and tax law involving property
classifications for depreciation purposes: “The
detailed engineering approach from actual cost records, or
‘detailed cost approach,’ uses costs from
contemporaneous construction and accounting records. In
general, it is the most methodical and accurate approach,
relying on solid documentation and minimal
estimation.” Why Do You Need
a Specialist? While many
CPA’s are aware of the benefits surrounding cost
segregation, they often do not employ true engineering-based
methods: therefore, only a small number of building
components are identified for accelerated depreciation. Many
times, where building cost information is not available, the
entire cost of the building is depreciated over the 39 or
27.5 year life assigned to real property. In this situation,
property owners are incorrectly depreciating their assets
and not taking full advantage of the benefits currently
available from the tax code. But through an
engineering-based cost segregation study, a wide range of
building components, such as electrical installations,
plumbing, mechanical components and finishes can be
identified and reclassified into the shorter-lived asset
classes. The studies allow property owners to accelerate the
depreciation on as much as 25-60 percent of typical
buildings. Cost segregation
specialists do not replace the essential role the CPA plays
in tax planning and preparation; rather the two complement
each other. Cost segregation utilizes a unique combination
of construction estimating and tax expertise to properly
dissect construction information, compute estimates, and
identify subcomponent costs. For new construction, a review
of construction invoices alone is not sufficient and for
acquired properties, construction cost information is
frequently not available or is incomplete. Many CPA firms
lack either the necessary tax expertise to properly
segregate the different types of property, or the
engineering expertise necessary to analyze construction
drawings and conduct engineering cost estimates. It is
important to understand that IRS agents are trained to
review the preparer’s credentials and level of
expertise as part of an audit, since that can influence the
quality and accuracy of a cost segregation study. Additionally, there
are no set rules that you can use to determine if property
is eligible. For example, a light fixture in one room may
qualify as Sec. 1245 property (property eligible for a
shorter accelerated depreciable life), while the exact same
light fixture in the very next room may not qualify because
of various factors and circumstances on how and why
it’s being used. This applies to every asset in the
building, and the onus – to prove and substantiate that
each asset qualifies – is on the taxpayer. This is done
by understanding the characteristics of each asset and
knowing the circumstances for which your position can be
supported. A Valuable
Strategy Cost segregation is
one of the most valuable tax planning strategies available
to commercial real estate owners today. Effectively, cost
segregation studies provide more precisely segregated
property information, enabling building owners to achieve
the maximum tax benefit allowed by law, which can have a
direct and sizable impact on their cash flow. Without utilizing
this tool, taxpayers are providing the IRS an interest free
loan for many years. There was a period
when having a cost segregation study preformed was a good
idea. In today’s economic environment –it’s
not only a sound idea, it’s critical in order to
protect your cash flow.
About
the author: Garry E. Adams has over 25 years of CPA,
finance and commercial real estate development experience.
Currently, Garry is President of Capital Realty, Inc., a
financial and real estate services firm based in Sherman
Oaks, CA. He is also associated with Cost Segregation
Partners, LLC. He can be reached at gadams@CapitalRealty.net.