TO SHELTER LARGE AMOUNTS OF MONEY FROM TAX LIABILITY, ENGAGE IN A COST SEGREGATION STUDY.
Tax-deferral strategies are a great way to minimize taxes, and cost segregation and section 1031 Exchanges are two of the most valuable tax-deferral strategies available to commercial real estate owners today. We've dealt with 1031 Exchange programs in the previous two chapters. Now we turn to cost segregation analysis.
New investors are improving cash flow and finding immediate tax savings from their business properties by utilizing this specialized depreciation program called cost segregation. It's a program we are increasingly advising new real estate pros to employ.
A cost segregation study (CSS) is the process of reviewing the costs a taxpayer incurs to acquire, construct, or improve real estate. It identifies the specific types of assets being placed in service and often leads to a cost allocation that assigns part of the cost to personal property.
In a section 1031 Exchange, real property must be replaced with real property in order to defer the gain. In general, state law determines the definition of real property under section 1031. In contrast, the definition of real and personal property for tax depreciation purposes is determined under federal law. State law tends to classify fixtures in a building as real property. Therefore, property such as wall coverings, carpeting, special-purpose wiring, or other installations affixed to the building can be considered real property under state law and like kind for section 1031 purposes, but personal property in cost segregation studies. Thus, real estate owners can benefit from both the gain deferral under section 1031 for real estate exchanges and the enhanced cost recovery deductions of the cost segregation study.
Cost segregation brings a great IRS-recognized tax savings strategy to commercial property owners interested in retaining cash.
When investing in real estate, many people lose sight of the fact that a property has numerous components, making it one of the most unique investment vehicles available.
With cost segregation you depreciate more of the property over a shorter period of time. With a cost segregation study, you depreciate more of this property over a shorter period of time.
Cost segregation can be complex because the tax laws provide many different asset lives and categories that may be applicable to a building project.
Normally, when you build a building the general contractor provides you with a monthly draw request. In this draw request the contractor combines different construction costs into single line item categories (i.e., concrete, plumbing, electrical, etc.). These categories have numerous components. For example, the electrical contract might have light fixtures, panel boards, conduit and wiring, etc., buried within the single line item. Once the building is completed, you give your project-related construction costs to your accountant to prepare your depreciation schedules and tax returns.
Since the contractor didn't break out the different components of the building, the accountant is hard pressed to identify the different components of the building. Therefore, the accountant usually places the entire project-related construction costs into a long tax life, typically 39 years (nonresidential real property).
Construction-related soft costs historically have been lumped together as part of real property. However, with cost segregation, these soft costs can be allocated to various components of the property, many of which have shorter depreciable lives than the real property component. The result is a faster write-off of costs previously included as real property.
Cost segregation has been around since the 1960s in one form or another. It has been called component depreciation, an investment tax credit, and various other names. The primary goal of cost segregation is to identify building components that can be reclassified from real property to personal property. This goal results in a substantially shorter depreciable tax life and accelerated depreciation methods.
Cost segregation is a strategic tax savings tool that permits companies and individuals to increase their cash flow by accelerating depreciation expense (i.e., 5- and 7-year personal property and 15-year land improvements/real property). Ordinarily, the cost of real or section 1250 property is recovered over lengthy periods (27.5 and 39 years for residential and nonresidential property, respectively), using the straight-line method of depreciation. Personal, or section 1245 property is recovered over considerably shorter periods (5, 7, or 15 years), and employs ac celerated (''front-end loaded'') methods of depreciation, such as 200% or 150% declining balance.
The problem arises when you're doing a straight-line depreciation on a commercial property or an investment property other than residential—residential is 27.5 years, commercial property is 39 years. So when you buy a commercial property and you depreciate that over 39 years you are depreciating that over a long period of time. So you're losing the value of that depreciation because you can't use it unless you own the property for 39 years; then you would get the full value of that depreciation
Cost segregation and 1031 Exchanges are not mutually exclusive. It is possible to use both in the same transaction. A 1031 Exchange is used as the result of a sale of a property. Cost segregation is used upon the purchase of a property.
Cost segregation studies can be performed on purchased or newly constructed buildings. Studies can be performed for buildings placed in service as far back as 1987, even if the year is ''closed'' for tax purposes. Recently issued IRS revenue procedures permit taxpayers who have claimed less than the allowable depreciation to claim the omitted amount over a four-year period. In addition, the segregated components continue to be depreciated over shorter lives from then on.
Real estate owners and investors can use cost segregation studies to accelerate overall property depreciation, which can produce a current income tax benefit. This tax benefit applies to commercial, industrial, multifamily, and special-purpose real estate. Typically, the more specialized and costly the property, the greater the tax benefits. Often, these benefits are neither captured nor maximized by many real estate owners, because they neglect to have a cost segregation study done on their property.
A cost-segregation study is an asset-reclassification strategy that accelerates tax depreciation deductions. Simply put, certain real estate is reclassified from long-lived real property to shorter-lived personal property for depreciation purposes. Depreciation deductions for the personal property then can be greatly accelerated, producing greater present-value tax savings.
An analysis of costs can be conducted from either detailed construction records, when such records are available, or by using qualified appraisers, architects, or engineers to perform the allocation analysis. In both instances, a tax expert also is needed to identify the types of property that can qualify as short-lived assets and can be segregated from long-lived assets.
Under prior law taxpayers would separate a building's parts into its various components—doors, walls, and floors. Once these components were isolated, taxpayers would depreciate them using a short cost-recovery period. CPAs referred to this practice as component depreciation. The introduction of the accelerated cost recovery system (ACRS) and the modified accelerated cost recovery system (MACRS) eliminated the use of component depreciation, but not the use of cost segregation.
The legislation and procedures used in engineering-based cost segregation studies have been around since the enactment of the Investment Tax Credit (ITC) in 1962. It had been possible prior to 1986 to front-load the depreciation on an apartment complex to get 200% of the losses of the depreciation in one year; this made real estate a tax shelter.
With the repeal of the ITC and the enactment of the rules limiting passive losses in 1986, most companies assumed that engineering-based cost segregation provided no further benefit under the new tax law. However, in a 1997 tax court case involving Hospital Corporation of America, the taxpayer successfully defended the application of engineering-based costs.
The IRS now has acquiesced to the viability of engineering-based cost segregation as a legitimate method to differentiate real and personal property under current tax law.
In it the Tax Court permitted HCA to use cost segregation with respect to a multitude of improvements.
Critical to the Tax Court's analysis was that in formulating accelerated depreciation methods Congress intended to distinguish between components that constitute IRC section 1250 class property (real property) and property items that constitute section 1245 class property (tangible personal property).
This distinction opened the doors to cost segregation.
Armed with this victory, taxpayers have increasingly begun to use cost segregation to their advantage. The IRS reluctantly agreed that cost segregation does not constitute component depreciation. Moreover, cost segregation recently was featured in temporary regulations issued by the Treasury Department.
In a chief counsel advisory (CCA), however, the IRS warned taxpayers that an ''accurate cost segregation study may not be based on noncontemporaneous records, reconstructed data or taxpayers' estimates or assumptions that have no supporting records.''
TO DEFER THE MAXIMUM AMOUNT OF INCOME TAX, COMBINE COST SEGREGATION ANALYSIS WITH A 1031 EXCHANGE.
Combining cost segregation and 1031 Exchanges allows newly minted real estate pros to defer the maximum amount of income taxes. Using cost segregation on replacement property acquired in 1031 Exchanges, budding real estate pros can reclassify real property as personal property in order to obtain faster depreciation write-offs. This is a particularly good option if the owner is exchanging up in value.
However, in certain situations cost segregation may give rise to depreciation recapture as ordinary income in otherwise nontax-able exchanges, and considering that most accountants have no idea what cost segregation analysis is, you must be very careful whom you hire to represent you.
Depreciating Items in the Property
If you own five condominiums, you can lump them together and actually do cost segregation.
Cost segregation enables you to offset passive income with passive losses. So if you have a property you've owned for some time and its generating income but you no longer have a depreciable base, you can now buy another property. You can use a cost segregation study to increase the losses on the new property to offset the taxable income on the older property.
People say real estate is still one of the best legal tax shelters once you understand the methodology in how to improve and increase that depreciation. Now you can do this with new or existing property. Cost segregation applies to new construction purchases, leasehold improvements, exhausted property, 1031s, and inherited property.
If a budding real estate pro acquired a commercial property or improved a commercial property since 1987, and he or she has a cost basis of at least $500,000 and plans to own the property for at least three years, he/she can benefit from additional depreciation deductions using cost segregation.
One of the big advantages is this: assume you own multiple condo units. You can depreciate—you can kind of lump them together—and componentize those particular units. Component depreciation allows taxpayers to depreciate structural components separately—based on the useful life of the component.
The component that you plan to use has to be a property attached to the building, not something that you could remove that easily.
The IRS has come out with some rulings supporting cost segregation analysis.
One example: In a typical medical facility using the 200% declining-balance method, with a 6% discount rate, the distinction means a present-value difference in the value of deductions of nearly 47% of original cost.
In other words, under former tax credit rules regarding the definition of section 38 property, certain costs, which have been classified as real property, and are subject to 39 years depreciable life, should be classified as personal property subject to 5, 7, or 15 years depreciable life.
That means you can reclassify the roof, the windows, the studs, the sheet rock, the floors, the paint that has a useful life (but it doesn't last 39 years), the parking lot, and much more. When you start to itemize all these items—and there could be thousands of them—you now change the life factor of these particular components.
As a result, you now shift that depreciation from the 39 years—you bring it forward. You wind up with a higher loss factor in the early years. What does that mean for you?
If you have income from other properties or if you are considered a real estate professional for IRS purposes, and you have income from other sources, you can take the losses from a real estate transaction and offset them against that other gain or ordinary income.
If you have money earning from something else, and you wish to be classified as a real estate professional, you must have worked 750 hours a year in real estate.
One can use the figure $10 million. The number is irrelevant; it's the concept that matters. This is the depreciable cost basis for your property minus the land.
The current cost of property is $10 million. The percentage of property assigned to a shorter depreciable life is zero.
As a result of the cost segregation study, the depreciation in the first year is $400,000. So 40% of the value of the building is going to be recharactierized and changes the depreciable base. You'll change $4 million to a ten-year basis.
The initial depreciation using 39 years on the $10 million was $256,000. The new estimated depreciation is $706,000. So there is a net difference of $450,000. This gives an estimated cash tax savings of $180,000.
You've done nothing different. All you did was analyze it better.
If you sell the property you can do a 1031 Exchange and then once you die, you eliminate the taxes. When you die that depreciable base goes back up to the new value at the time of your demise. So in other words, you eliminate it. If you depreciated this over a five- or ten-year period, and you then die, the property, if valued at $20 million, starts off a new tax basis for your heirs.
What can your heirs do at that point? They can do it all over again.
Cost segregation studies are most useful when the taxpayer is exchanging up in value significantly, or exchanging from nondepreciable property, such as land, to depreciable property.
For example, installed carpet purchased with a facility is considered personal property for depreciation purposes and recov ered in a five- or seven-year period using the 200% declining balance method of depreciation. If this is not done, the carpet would be included in the value of the real property and its cost would be capitalized and recovered on a straight-line basis over 39 years.
Land improvements, however, remain section 1250 property (real property). Section 1245 property (personal property) has significant depreciation recapture rules in a section 1031 Exchange; generally the replacement property must contain the same value of section 1245 property as the relinquished property, or the taxpayer will recapture the difference (up to the realized amount) at ordinary income tax rates.
As an example, Joan, the owner of a manufacturing facility, had a cost segregation study performed in 2000 that reclassified $1 million of real property as section 1245 property. In 2004, after realizing the benefits from $430,000 of depreciation deductions, Joan exchanged the facility for an office building of equal value and equity.
Since the section 1245 property in the relinquished property still is valued at $1 million, Joan typically would pay no tax on the exchange.
However, the office building has only $700,000 of section 1245 property; the remaining $300,000 of value is section 1250 property. Therefore, Joan will recapture and pay ordinary income tax on $300,000 of the prior depreciation deductions due to the difference between the $1 million of section 1245 property in the relinquished property and the $700,000 of section 1245 property in the replacement property.
Despite the potential of future taxes in a section 1031 Exchange, cost segregation still can be justified due to the increase in present value of the accelerated depreciation deductions. Based on the fundamental principle of the time value of money, a dollar saved today through reduced taxes always is worth more than a dollar in later years. Furthermore, Joan could have exchanged into other real property with similar amounts of personal section 1245 property and avoided the recapture tax altogether.
Engineering-based cost segregation studies take assets that have been classified as real property for federal income tax purposes and, using engineering-based analysis techniques, reclassify the property that should have been classified as personal property into the shorter, appropriate class lives. The engineering-based cost segregation study provides tax preparers with the information and supporting documentation needed to depreciate assets over the appropriate, shorter tax lives.
Real property recovery periods range from 27.5 to 39 years and employ the straight-line method of depreciation. Personal property can be depreciated in as few as five years and employ a 200% or 150% declining balance method of depreciation. The result is an increase in current year depreciation expense due to a significantly shorter depreciable tax life and a front-end-loaded method of calculating the depreciation expense. The resulting increase in depreciation expense typically yields a significant decrease in income tax liability.
A good cost segregation firm brings engineering, accounting, and tax expertise together in a unique marriage to ensure maximum benefit for the property owner. This expertise also ensures that the engineering study will be delivered in an understandable, supportable, and technically sound format.
In Chapter 4 of the IRS Cost Segregation Audit Techniques Guide, the first element of a ''quality cost segregation study'' is ''preparation by an individual with expertise and experience.''
The Audit Techniques Guide goes on to say: ''Preparation of cost segregation studies requires knowledge ofboth the construction process and the tax law involving property classifications for depreciation purposes. In general, a study by a construction engineer is more reliable than one conducted by someone with no engineering or construction background. Experience in cost esti mating and allocation, as well as knowledge of the applicable law, are other important criteria.''
Cost segregation methods employed nationally vary greatly in their detail and scope. Cost segregation professionals need to spend several hours, even days in some cases, at the site verifying the accuracy of blueprints and specifications or taking necessary measurements to calculate an asset's costs and segregate them. Selecting a firm that uses qualified professionals with years of significant, relevant experience can be an important differentiator in the quality of a cost segregation study.
In this example we see the tax benefits of cost segregation.
A company constructed an $11 million skilled nursing facility in 1988. During the first ten years of operation, depreciation expense was calculated as $3.3 million. As a result of a cost segregation study performed in 1998, the company was able to increase its depreciation expense by more than $1.6 million during the next four years. This increase produced discounted present-value tax savings and additional cash flow of more than $340,000 for the company.
In another example, another property acquired in 1987 cost less than $1 million. Additions worth more than $8 million were added from 1992 through 1997. As originally calculated, the depreciation expense from 1987 to 1998 was $3 million. In 1999, a cost segregation study identified items such as land improvements, kitchen and medical-related equipment, decorative mill-work, wall coverings, telecommunications wiring, and emergency generators as personal property, resulting in an increase in depreciation expense of $1.3 million. This reclassification of property resulted in discounted present-value tax savings and additional cash flow of more than $280,000 to the facility's owner.
When Should You Begin a Cost Segregation Study?
The ideal time to begin a cost segregation study is when plans to construct, remodel, or expand an existing building, or to purchase a building, are first drafted. Ideally, the cost segregation study should be completed during the year the building is placed in service.
If you didn't complete a cost segregation study when the building was first placed in service a cost segregation study can still be performed. Recent IRS procedures make it easier for you to go backwards, allowing you to change your accounting method as far back as 1987 without filing an amended tax return. You can recapture all of the understated depreciation expense for any asset that has been improperly classified in previous years. Here's an example.
Let's say you placed an asset in service in 1990. The cost of the asset is $100,000, the tax life you gave this asset is 27.5 years—and the depreciation method was straight-line. The asset has been depreciating for ten years (approximately 32% depreciated). The remaining basis of this asset is $68,000. The correct life of this asset should have been five years.
The IRS states that if you have truly made a classification error, as in this case, you can make a correction to this asset without being penalized. Therefore, you can bring forward that understated depreciation expense ($68,000) in the year that you are requesting the change in accounting method. According to the IRS, the understated depreciation expense deduction must be prorated over a four-year period beginning with the year of change.
To determine whether you might qualify for this change in accounting method procedure, first look at your depreciation schedule. If you placed a building in service prior to 2000 and the entire project cost of the building (real property only) is sitting at a 27.5- or 39-year life, you may want to look at having a cost segregation study done.
What Does a Cost Segregation Study Entail?
A cost segregation study is a comprehensive analysis of the total cost or value of building and site improvements. Cost segregation studies typically do not include analyzing the value of land, furniture, fixtures, and equipment. These studies apportion the value or cost of all specific components of the building and site improvements to certain specific federal tax depreciable-life categories.
To optimize the reclassification from longer lives to shorter lives, a detailed analysis of the property is required. Qualified engineers and appraisers typically perform these analyses. An understanding of specific tax guidelines and regulations, tax court cases, revenue rulings, and current legislation is required to conduct such studies. Cost segregation studies should be utilized for any taxpayer who constructs a building, acquires a property, expands an existing facility, or changes the tax basis of real property.
In addition, cost segregation studies can be conducted on properties constructed or acquired in the past, even if no cost segregation study was performed at the time the property was placed in service.
Generally, cost segregation methodology requires establishing a complete and thorough understanding of the total cost or value of the real estate asset in order to determine the total depreciable tax basis.
In new construction, further details of construction cost information, both direct and indirect, are typically utilized for the building. ''Direct costs'' are costs for labor and materials necessary to construct the asset. ''Indirect costs'' are items that are required for the project, but not directly associated with specific labor and materials. Some examples of indirect costs include architectural and engineering design fees, contractor overhead and profit, permit fees, and construction interest. These indirect costs are allocated to direct costs on a pro rata basis.
Next, the cost segregation analyst inspects the property to gain a full comprehension of the function, nature, and operation of the various building components. The analyst must also confirm the accuracy of the construction or property documents. This is critical in determining the specific property classifications that are associated with depreciable federal tax lives. It establishes appropriate property units by asset function.
The central and most significant step in the cost segregation study is the specific identification and quantification of the asset components that qualify for 5-, 7-, or 15-year depreciable tax lives. Often, for newly built property, detailed construction cost information can provide a breakdown of the various costs.
A cost segregation study analyzes and supplements the cost information with ''quantity take-off estimates'' that serve to reclassify even more property into a shorter tax life. Quantity takeoff estimating must follow generally accepted engineering and cost estimating procedures. These procedures include the estimation of material and labor quantities and the determination of cost estimates from recognized construction estimating sources or other supportable sources.
The last step in a cost segregation study is to document and report the findings. Generally, the identification and quantification process is supported with documentation and calculations. These are typically referenced by use of an automated, computer-based cost segregation report. This report provides a description of the property, the steps taken to determine the quantification and property life determination, and the supporting detail.
The analysis procedures require that a consistent, logical, and supportable report be produced. There are a number of other supporting and related calculations that are also part of the process. A well-conducted study always includes a detailed, referenced, work paper file, which supports the final conclusions of the study, and also provides an audit trail. When similar property portfolios exist, a sampling methodology may be applied to support the analysis.
As part of MACRS, nonresidential real properties are depreciated over 39 years via straight-line depreciation. Some assets, which are often classified as real property, however, may be depreciated over five or seven years, if they are nonstructural components.
These assets are defined under section 1245(a)(3) of the Internal Revenue Code as ''Personal Property.'' Yet, there is no specific definition of ''personal property.'' Treas. Reg. [sections] 1.48-1(c) defines the term ''tangible personal property'' as ''any tangible property except land and improvements thereto, such as buildings and other inherently permanent structures, including items which are structural components of such buildings or structures.'' Several factors were determined in Whiteco Industries, Inc. v. Commissioner, 65 T.C. 664 (1975), to constitute whether property is inherently permanent. These factors include:
When section 1250 property is reallocated to section 1245, the differences can be great. It takes a unique combination of engineering and tax expertise to properly analyze, as we've noted earlier, construction information, compute industry-standard estimates, and identify and segregate the subcomponent costs needed for cost segregation, however. CPAs without that expertise might consider hiring a consultant.
Tax advisers should alert taxpayers to the possibility of future depreciation recapture so they can anticipate paying some tax in the later exchange or making sure that the replacement property has sufficient amounts of section 1245 property to avoid recapture.
There also are recapture rules for section 1250 property in an exchange, but they are less onerous. Only the excess depreciation over straight-line depreciation (the additional depreciation) is subject to recapture. Land improvements such as sidewalks, fences, and landscaping are depreciated on an accelerated basis and can give rise to additional depreciation or recapture if the taxpayer does not acquire replacement property with an amount of section 1250 property equal to the additional depreciation.
For example, if you have $20,000 of additional depreciation from relinquished property disposition, you need to acquire only $20,000 of section 1250 property, including the building, to avoid recapture. Section 1250 recapture would be a problem, however, if you had additional depreciation and exchanges into raw land.
When combining tax-deferred exchanges under section 1031 and cost segregation, tax professionals must understand both the significant upside and the potential issues that are involved. With proper planning, using the two methods can provide a tremendous opportunity for taxpayers to defer income taxes into future periods and maximize cash flow in the current one through accelerated depreciation deductions.
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