Cost-segregation studies can help property owners increase their tax savings.
In recent years, many commercial real estate owners have become more familiar with the tax benefits of cost segregation. Due to cost and complexity, these studies were once only practical for large property owners. However, several boutique consulting companies have emerged, making the process more affordable for small-building owners as well. In addition, recent tax changes have made cost segregation a beneficial strategy for all commercial property owners.
Why Use Cost Segregation?
Cost segregation is the process of valuing and assigning the correct tax life to assets that are included in a building's construction cost or purchase price. For example, an acquired office building's price not only includes its structure (39-year tax life), but also landscaping (15-year tax life), carpeting (five- or seven-year tax life), data cabling (five-year tax life), and a number of other shorter-lived assets. In many instances, property owners unknowingly classify a property's entire depreciable basis (the purchase price minus land and other nondepreciable items) as real property. This seemingly small oversight significantly reduces the property's after-tax returns.
During the last 18 months two changes have been made that affect cost segregation and real property depreciation benefits.
Previously Missed Deductions. For some time there has been conflicting information on whether or not taxpayers can catch up on previously missed depreciation deductions and how to account for such changes in an asset's depreciable life. In late 2003, the Internal Revenue Service issued guidance that a change in depreciation method or recovery period is a change in the accounting method. Revenue Procedure 2004-11 and a subsequent Chief Counsel Advice memorandum provided further clarification on the issues. Overall, the guidance is favorable for property owners as it allows them to file a relatively simple form to claim previously missed deductions.
For property owners who previously misclassified assets or who have not had cost-segregation studies performed on their buildings, this can lead to significant catch-up adjustments. For example, suppose an investor purchased an office building six years ago for $1 million. After learning about cost-segregation benefits, the investor commissioned a study earlier this year. The study showed that the original purchase price included $100,000 of carpeting, phone cabling, and other assets that should have been depreciated as personal property over seven years rather than as part of the building's structure over 39 years. By reclassifying the assets and claiming the catch-up adjustments, the property owner receives an additional depreciation deduction of nearly $80,000 in the current tax year. Assuming a federal tax rate of 35 percent, this reduces the current year's federal tax payment by $28,000. However, it is important to note that catch-up deduction adjustments often are treated differently at the state level and commercial real estate owners should consult local or state tax advisers for assistance.
Qualified Leasehold Improvements. As part of the American Jobs Creation Act of 2004, qualified leasehold improvements and certain restaurant property that is placed in service prior to Jan. 1, 2006, are subject to a 15-year tax life instead of the previous 39-year life. This change alone creates a sizeable tax benefit for property owners, but it is important to note that the cost of these improvements often includes a substantial amount of personal property — as much as 40 percent of the entire expenditure. When these personal property items are properly identified and valued, they can be segregated from the overall leasehold improvement for an even greater benefit.
These changes create opportunities for all commercial real estate professionals. For those involved in acquisitions or sales, the use of cost segregation results in improved after-tax cash flow, which may make deals more attractive. For example, if an investor wants to earn $20,000 per year in after-tax income but does not have enough capital to buy a property that generates an appropriate net operating income, he may be able to buy a less-expensive property and have a cost-segregation study performed. The study may reveal larger depreciation deductions, and therefore, allow for greater after-tax cash flow.
Cost-segregation studies also can be useful in lease negotiations. Landlords and leasing professionals should be aware of items that qualify for a shorter depreciable tax life so that tenant improvement allowances can be used specifically for these items.
Specialty properties, such as golf courses, amusement parks, and sports stadiums, among others, also can benefit from improved after-tax returns.
Choosing a Provider
While the benefits are significant, cost segregation is a complex process: A simple electrical outlet can have a tax life of 39, 27.5, 15, seven, or five years, depending on various factors. Add to this the complexity of accurately valuing multiple small assets — some reports contain more than 1,000 unique assets — and the importance of selecting a qualified professional to perform the study becomes apparent.
An audit technique guide used frequently by IRS examiners when reviewing cost-segregation studies states, “A study by a construction engineer is more reliable than one conducted by someone with no engineering or construction background. However, the possession of specific construction knowledge is not the only criterion. Experience in cost estimating and allocation, as well as knowledge of the applicable law, are other important criteria.”
Since more than 200 court cases and other forms of guidance involving asset classification exist, commercial real estate professionals should use care when evaluating prospective providers. At a minimum, preparers should have an engineering degree and five or more years of experience in preparing cost-segregation studies and defending the studies' results to the IRS. Previous management experience within a major accounting company's cost-segregation group also is beneficial as these firms provide thorough education on the various accounting aspects of cost segregation.
There are several acceptable approaches to performing a cost-segregation study, with a detailed engineering analysis being the most thorough. When evaluating prospective preparers, keep in mind that the results of engineering-based cost-segregation studies should be similar, regardless of who prepares the report. Be wary of consulting companies that claim to achieve greater cost-saving benefits than others.