Building owners and managers can significantly reduce their
taxes through a process called cost segregation. In fact,
cost segregation has become one of the most vital aspects of
real estate financing with tax consequences that can
significantly add to a facility’s bottom line. According to
federal tax laws, cost segregation consists of identifying
personal property assets that are grouped with real property
assets, then separating personal assets for tax reporting
purposes. In order to do this, one must hire an experienced
engineer who should have a well-rounded understanding of
construction finance, to produce a cost segregation analysis
that identifies and classifies personal property assets so
that depreciation time is dramatically truncated thus
reducing one’s tax obligations.
What is personal property? It consists of a building’s
non-structural elements, exterior land improvements, and
indirect construction costs.
The engineer that one retains will examine all blueprints as
well as architectural drawings, electrical plans, and
isolate structural and mechanical components from those that
are considered personal property. The cost segregation
report will also identify architectural and engineering fees
that can be segregated.
The report will identify “soft costs,” such as architectural
and engineering fees, that are components of the building.
In addition a well documented and thorough cost segregation
analysis will do the following:1. Maximize tax savings by adjusting the timing of deductions.
2. Create an audit trail to help resolve IRS inquiries.
3. Take advantage of retroactive benefits. Building owners and managers can capture immediate retroactive savings on property added since 1987. The rules have been amended so that you can now take the full amount of an adjustment in the year the cost segregation is completed.
4. Provide significant opportunities to reduce real estate tax liabilities.
5. And, under certain circumstances, permit building owners and managers to qualify for a special 30% bonus depreciation allowed by the Job Creation and Worker Assistance Act of 2002 or a 50% bonus depreciation allowed under the Jobs and Growth Tax Relief Reconciliation Act of 2003.
The cost segregation study will identify building costs that
would normally be depreciated over a 27.5 to 39-year period,
then reclassify those costs, resulting in an accelerated
method of depreciation. Such non-structural costs for such
items as carpeting, wall coverings, some aspects of an
electrical system, decorative lighting, indoor and outdoor
plants, sidewalks, and landscaping, can all be depreciated
during the much shorter periods of five, seven or fifteen
years.
The larger tax deductions will result in increased cash flow
and a lower cost of capital, especially during the first few
years following an expansion project, renovation, or
purchase. A cost segregation study can significantly help
identify opportunities for such periods of accelerated
depreciation.
In order for building owners and managers to take full
advantage of cost segregation opportunities, buildings must
have been purchased, constructed, renovated, or expanded
after 1987. While cost segregation is cost effective for
such new buildings, a well done study can uncover tax
deductions for buildings that pre date 1987. In addition,
buildings that are best suited for cost segregation should
have a cost basis that is greater than $500,000.
In addition to providing tax relief, cost segregation can
benefit building owners and managers in the following ways:1. Maximizing tax savings by adjusting the timing of deductions. When an asset’s life is shortened, depreciation expense is accelerated and tax payments are decreased during the early stages of a property’s life. This, in turn, releases cash for investment opportunities or current operating needs.
2. Creating an audit trail. Improper documentation of cost and asset classifications can lead to an unfavorable audit adjustment. A properly documented cost segregation helps resolve IRS inquiries at the earliest stages.
3. Playing Catch-Up: Since 1996, taxpayers can capture immediate retroactive savings on property added since 1987. Previous rules, which provided a four-year catch-up period for retroactive savings, have been amended to allow taxpayers to take the entire amount of the adjustment in the year the cost segregation is completed. This opportunity to recapture unrecognized depreciation in one year presents an opportunity to perform retroactive cost segregation analyses on older properties to increase cash flow in the current year.
4. Additional tax benefits. Cost segregation can also reveal opportunities to reduce real estate tax liabilities and identify certain sales and use tax savings opportunities.
Under certain circumstances, segregated assets may qualify
for a special 30% bonus depreciation allowed by the Job
Creation and Worker Assistance Act of 2002 or a 50% bonus
depreciation allowed under the Jobs and Growth Tax Relief
Reconciliation Act of 2003.
An example of Cost Segregation: Suppose an individual
purchases a building for $10,000,000 while the land is owned
by another entity. If the purchaser does not use cost
segregation, then straight-line depreciation over 39 years
must be used.
If, however, an engineer is retained and produces a report
that shows that of the total purchase price, $9,000,000
should be for the building and $800,000 for a parking lot,
and $50,000 for landscaping and shrubbery, the facility
owner could save more than $100,000 assuming a tax rate of
35% and 5% discount rate.
There is an another example of the tax savings that can
result from cost segregation. Suppose a cost segregation
analysis shows that a building’s siding had an initial value
of $200,000. Five years later, it has a value of $150,000
and must be replaced. The facility owner could deduct
$150,000 as a loss. Without a cost segregation study, the
owner would be not able to take the deduction because the
siding’s tax basis and the cost basis of the building would
not have been itemized as separate entities.
Altogether, a cost segregation study is an essential
fiduciary component when one does any of the following:• Building a new facility
• Acquiring an existing building,
• Renovating an existing facility, or
• Expanding a facility.