Stimulus package gives owners extra appreciation for depreciation.
On Feb. 13, President Bush signed the Economic Stimulus Act of 2008 into law. The legislation is intended to encourage spending by providing advance refund rebates to individual taxpayers along with business tax breaks in the form of accelerated depreciation deductions. While many American households are focused on the rebate checks, commercial property investment professionals can increase their bottom lines and investment returns by taking advantage of the one-year bonus depreciation provisions through the use of cost-segregation studies.
Cost segregation allows taxpayers to increase their depreciation deductions over normal methods by classifying personal property away from long-lived building periods and into shorter recovery periods. This gives owners increased options and flexibility when deciding when and where to allocate capital. The increased cash flows can be taken from the income stream to finance separate projects, strengthen reserves in existing properties, enable owners to be more competitive by allowing for more tenant/leasehold improvements, or augment debt service payments. The 2008 additional bonus depreciation provisions significantly enhance the benefits of cost-segregation studies, allowing taxpayers to maximize their depreciation deductions, recognize lower tax burdens, and increase after-tax cash flows.
Under the new legislation, the bonus depreciation rules formed in 2002 and eligible through 2005 have been reopened for property placed into service during 2008. Under these rules, 50 percent of the depreciable basis is deducted immediately for qualifying property. The remaining reduced basis is depreciated over its normal class life and method. To qualify, property must be eligible for depreciation under the modified accelerated cost recovery system rules with a recovery period of 20 years or less, a water utility property, off-the-shelf computer software, or qualified leasehold improvements. Qualifying property must be constructed and placed into service after Dec. 31, 2007, and before Jan. 1, 2009, and may not have been the subject of a written binding contract for its acquisition in effect before Jan. 1, 2008.
Understanding Cost Segregation
Cost segregation is a combined tax and engineering analysis of a building’s structural components. By properly segregating the construction costs or purchase price of a project out of the building and into personal property or land improvements, owners significantly can increase their after-tax cash flows by accelerating their tax deductions to the early life of the project.
As introduced by the Tax Reform Act of 1986, MACRS established class lives for tangible property based upon the taxpayer’s business activities. Under MACRS, the building components can be broken down into 39-, 27.5-, 15-, seven- or five-year recovery periods depending on the asset’s installation and use. The goal of cost segregation is to properly allocate construction costs into shorter-life asset classes (those with 15-, seven-, and five-year recovery periods), as opposed to the standard nonresidential real property (39-year life) or residential real property (27.5-year life).
Cost-segregation studies require a detailed analysis of all project costs and documentation by specialized engineers with in-depth knowledge of the current tax laws. Cost documentation typically analyzed may include the project’s general ledger, direct vendor invoices to the owner, and contractor progress billings and change orders. Cost detail that is not directly itemized in any of the project invoices can be estimated from the as-built construction blueprints. Through this process, assets can be moved from classification as a part of the building into classes with shorter, more tax-advantageous recovery periods.
However, not all assets are created equal. The tax treatment for two identical assets may differ based upon several factors including their use, manner of attachment, and function. For example, a 10-foot copper pipe servicing the dishwasher in a restaurant’s kitchen would qualify as tangible personal property and could be reclassified as a five-year asset along with the dishwasher. However, an identical piece of pipe servicing the restaurant’s restroom sinks would be required to remain as 39-year real property as it is not directly allocable to personal property.
Other examples of assets that typically are reclassified into shorter-life categories include carpeting, vinyl composition tile, decorative millwork, cabinets and countertops, decorative accent lighting, and electrical distribution to machinery and equipment.
Illustrating the Benefits
To understand the value of cost-segregation studies, assume an owner spends $10 million in construction costs for a new distribution center. Through cost segregation, $1.5 million of personal property costs with a five-year class life and $1 million of land improvement costs with a 15-year class life are allocated out of the building’s structure. The associated accelerated deductions are worth an additional $350,000 in net present value benefit over the building’s life with an assumed 35 percent tax rate and 6 percent discount rate. The increase in cash flows to the taxpayer over the first five years is approximately $530,000 above what otherwise would have been available without cost segregation. These benefits are improved dramatically by the bonus depreciation provisions in the new economic stimulus legislation. By deducting 50 percent of the segregated costs in the first year, the net present value benefit in the previous example increases to $430,000 and provides a cash flow savings over a standard depreciation of $650,000.
Commercial property owners should exercise caution when choosing depreciation methods and lives. Taxpayers with significant net losses from previous tax years may not receive much benefit if the current and future periods do not recognize or are not forecast to recognize significant taxable income. Likewise, taxpayers constructing property with the intention of selling shortly thereafter may not receive the anticipated benefits due to depreciation recapture.
By seeking the advice of experienced engineering and accounting professionals, property owners can ensure they are receiving the most bang for their depreciation bucks. To realize this full benefit, a project owner can retain the services of an accounting expert that specializes in analyzing both the tax and engineering aspects of fixed assets. Qualified firms not only should have in-house cost-segregation engineers with tax expertise to properly reclassify assets according to existing tax authorities, but also the technical knowledge of the construction industry to appropriately quantify these costs.