Commercial Real Estate Owners' "Stimulus Check" Opportunity

This article is reprinted with the author’s permission from the Florida CCIM Chapter’s 4Q09 quarterly newsletter “The Voice.”

The Joint Committee on Taxation estimates that U.S. businesses will benefit by $34 billion in 2010 as a result of tax refunds under the Workers Homeownership and Business Assistance Act of 2009. One goal of the legislation is to put cash back into the hands of taxpayers via a net operating loss tax provision enabling a refund on taxes paid in prior tax years, potentially as far back as 2003. Rather than an actual “stimulus check,” it is a refund on taxes paid in prior years. Combining engineered cost-segregation studies with the temporary and generous provisions of this legislation may enable commercial property owners to obtain substantial tax refunds.

What are Engineered Cost-Segregation Studies?

Cost segregation is an Internal Revenue Service-recognized application by which commercial property owners can accelerate depreciation and reduce the amount of taxes currently owed. This savings may generate cash flow of 7 percent to 10 percent of building cost over the first five years of ownership. That is $70,000 to $100,000 per each $1 million of building cost. How does this work? The engineered cost-segregation study accelerates the depreciation of the building components into shorter depreciation categories such as five-, seven-, and 15-year rather than the conventional 27.5- and 39-year categories. Five- and seven-year categories may include items such as decorative building elements, electrical for dedicated computer equipment, and carpet. The 15-year category may include items such as site utilities, landscaping, and paving. For commercial real estate to qualify for this application, it must have been built, purchased, or renovated after 1986.

What do CPA Publications Have to Say About Engineered Cost- Segregation Studies?

The Journal of Accountancy says, “A taxpayer can substantially increase cash flow by segregating property costs.” California CPA says, “Cost Segregation is one of the IRS’ cash-flow secrets that CPAs, financial planners, real estate investment managers, and other professionals can use to realize tax savings for their clients.” The Journal of Accountancy continues, “Some taxpayers are reluctant to use cost segregation, equating it with a high-risk tax shelter. In truth, this reluctance is misplaced. If the cost of the components in the engineering report is well-documented, the cost-segregation technique is no more aggressive than using a permissible depreciation method under the Internal Revenue Code.” The Practicing CPA states, “A cost-segregation specialist can perform a nonintrusive yet detailed engineering study of a building’s walls, flooring, and ceilings; and its plumbing, electrical, lighting, telecommunications, heating, and cooling systems.” Therefore, even if your CPA has accelerated your carpet, cabinets, or parking lot, you are receiving only a small fraction of the benefits that can be unlocked by a qualified engineering cost-segregation firm.

What Are the Net Operating Loss Tax Provisions?

Both the American Recovery and Reinvestment Act, enacted February 17, 2009, and the WHBAA, enacted November 6, 2009, include net operating loss tax provisions. The ARRA provides eligible small businesses a net operating loss tax provision for the 2008 tax year. A net operating loss is defined as expenses exceeding gross income. Eligible small business is defined as those who have averaged less than $15 million in revenue for the last three years. Normally, an NOL is only allowed to be carried back two years. The ARRA allows the taxpayer to elect whether to carry back losses three, four, or five years, whichever provides the biggest benefit. Business Provisions of the ARRA on www.irs.gov states, “For small businesses that were profitable in the past but lost money in 2008, this could mean a special tax refund.” The IRS Commissioner Doug Shulman stated, “The new net operating loss provision could throw a lifeline to struggling businesses, providing them with a quick infusion of cash.” He continued, “We want to make it as easy as possible for small businesses to take advantage of these key tax benefits.”

The WHBAA expanded the net operating loss tax provision to nearly all U.S. businesses for either the 2008 or 2009 tax year. Ineligible companies are limited to TARP recipients, federal mortgage agencies, companies in which the government owns stocks, and affiliates of any of the above taxpayers. All others are allowed a one-time three-, four-, or five-year NOL carryback, which can be applied to either the 2008 or 2009 tax year. The WHBAA allows eligible small businesses to utilize the net operating loss tax provisions for both 2008 and 2009. Unlike the ARRA, the WHBAA has a 50 percent limitation on the fifth year before the loss year. Taxable income in the other four carryback years can be fully offset by any remaining NOL. Surprisingly, the WHBAA legislation is even taxpayer friendly in its Alternate Minimum Taxable Income Net Operating Loss provisions. Many CPAs feel that taxpayers are unlikely to see legislation this generous again for many decades.

Using the NOL Carryback Provision

John Doe Property has taxable income of $2 million per year from 2004 to 2008. Unfortunately, John Doe Property generates a net operating loss of $5 million for 2009. Since it elects a five year carryback for its 2009 NOL under the WHBAA, it claims a deduction of 50 percent of its 2004 taxable income, or $1 million. Next, $2 million of the remaining $4 million NOL balance fully offsets its taxable income of $2 million in 2005. Finally, the last $2 million of NOL is fully exhausted against its 2006 taxable income of $2 million. Basically, the provisions of the WHBAA have increased the carryback period allowable from two to five years. Since the taxes paid in 2007 have still not been recovered, this example also demonstrates the need for cost segregation to still be applied to be able to achieve the maximum tax refund.

Cost Segregation Combined with NOL Carrybacks

Since cost segregation generates substantial increases in depreciation expenses, even businesses with taxable income may have an NOL after the application of cost segregation. If cost segregation generates an NOL, then it can be treated as any other NOL. This means that it can be used against current taxable income, carried forward up to 20 years, or can now be carried back three, four, or five years. For example, a Florida owner of retail strip centers recently had engineered cost segregation studies performed on two centers with a total building cost of $10.9 million. Despite the exclusion of many leasehold improvements that were 100 percent owned by the tenants (which reduced the amount of potential five-year category items and thereby not increasing the depreciation expense as substantially), the engineered cost-segregation studies generated $1,172,261 in additional depreciation expenses for the 2009 tax year. At a 35 percent tax rate, the engineered cost-segregation studies generated an increased cash flow from tax savings of $410,291.

In summary, if a commercial real estate owner has taxable income from 2009, then the results of the engineered cost-segregation study can be applied to reduce its 2009 taxable income and increase its cash flow. If a commercial real estate owner does not have taxable income in 2009, then the study will generate a larger NOL which can be carried back to receive a larger refund. Although Fortune 500 companies and the big four accounting firms were quick to take advantage of the engineered cost-segregation application when it became available in 1997, it is just beginning to gain traction among small- and medium-size commercial real estate owners and their CPAs due to the decrease in cost of these studies. With the temporary and generous NOL carryback flexibility created under the stimulus bills and the affordability of the studies, there has never been a better time to apply engineered cost-segregation studies to your assets.

Actual Savings By Engineered Cost-Segregation Studies

Property type Total property cost Five-year cash flowfrom tax savings
Retail store
$273,000
$29,214
Warehouse/office
$300,000
$18,134
Leasehold improvement
$500,000
$38,101
Office condo
$575,000
$37,084
Retail strip center
$843,000
$63,877
Retail store
$873,000
$105,277
Manufacturing warehouse
$1.1 Million
$59,800
Distribution warehouse
$1.2 Million
$111,496
Assisted living facility
$1.3 Million
$82,846
Medical facility
$1.3 Million
$88,459
Leasehold improvements
$1.4 Million
$131,569
Retail store
$1.7 Million
$143,202
Assisted living facility
$4.1 Million
$203,257
Warehouse/office
$5.2 Million
$312,687
Warehouse
$6.3 Million
$248,559
Medical facility
$8.9 Million
$347,281
Apartments
$15.1 Million
$570,288
Retail strip center
$22.3 Million
$848,160