Cost segregation studies deliver earlier than expected tax breaks for US commercial property owners, says Jeffrey D. Hiatt.
In today’s economy, commercial property owners in the United States face an uphill battle in finding the funds to make the necessary improvements to retain and/or enhance a property’s value. That can create a vicious cycle where the property annually loses value because the cash flow to make improvements is just not there. A cost segregation study offers the commercial property owner who may not have the cash flow a viable means to raise funds for improvements.
How? “Cost seg” studies provide property owners an opportunity to write off depreciation of building assets over a shorter period than the 39-year depreciation period that’s typical for real property assets in the United States. This can generate funds in the form of a larger tax deduction. The funds that would have been paid in income tax could then be reinvested in renovations for that property or even leveraged to help acquire another property.
A cost seg study itemizes assets in a building into real property assets and personal property assets. Loosely speaking, real property refers to anything connected to the structure of the building (eg the foundation, the ceiling, walls, etc.). Personal property assets can range from non-structural items like carpeting to aesthetic improvements like resurfacing floors, a paint job, landscaping, etc. By separating personal property assets, which have a shorter life expectancy than real property assets, you can claim a greater rate of depreciation over a shorter period of time.
For example, let’s say you buy an inn or resort with millwork and IT wiring. Prior to cost seg studies, owners would have deducted depreciation of these items over 39 years instead of five or seven years. For many commercial property owners, the personal asset depreciation deductions can result in a sizable return.
While it is true that commercial property owners would eventually be able to claim that depreciation, in today’s economy, most would prefer to reduce taxes now versus 39 years from now. Today’s tax reduction provides them a competitive advantage.
Cost seg studies can be applied to a wide variety of commercial properties, including apartment buildings, restaurants, manufacturing facilities, grocery stores, office buildings and an assortment of other buildings (see box below). The process requires examination of any available building plans, site surveys, appraisals and/ or invoices. A site visit is required so project engineers can confirm details on the construction of the building.
After an inventory of assets is taken, a report of the building, per IRS standard, is then completed. The numbers from the report can then be interpolated into the building owner’s client's tax forms and filed with the next return.
Sounds fairly straightforward, right? Still, there are many misperceptions about cost seg studies that keep commercial property owners from leaping at this opportunity. For starters, people often confuse cost segregation studies with component depreciation, which the IRS abolished in 1987. The fact of the matter is that the IRS requires a study in order to take the proper depreciation.
Another misperception of cost seg studies is that it just invites an IRS audit. Like any other income tax return, you will get audited if you deduct for things you shouldn’t (in general, the IRS audits less than one percent of all returns filed). More than 400 court cases and rulings support cost segregation studies, most notably the watershed case involving the Hospital Corporation of America.
Some other common misperceptions include:
You have never heard of a cost segregation study: You probably have not unless you are working with an engineer or a firm specializing in them.
You have already completed a study: Cost seg studies must be conducted by a qualified professional or an engineer specifically hired to breakout the costs.
You won’t save any money: If you pay taxes, you save.
You’ll owe taxes when you sell the building: You will owe taxes anyway, except your deductions will be at ordinary rates and a majority of the taxes due on sale will be at capital gain rates. This is a permanent tax difference of 16 percent at the highest marginal tax rates.
You are out of luck if the building was constructed or acquired in prior years: Special provisions enacted by the IRS allow you to “catch-up” on any missed depreciation for any buildings built or acquired since 1987. No amended returns are required. The form 3115 allows taxpayers to get all missed depreciation in one lump sum, without amending a return.
You are in an alternative minimum tax situation: Cost segregation studies also reduce alternative minimum tax because alternative minimum tax depreciation is also accelerated when a study is completed.
You’ll get the deduction in the future anyway: Almost everyone would rather have the cash now to reinvest or meet current needs. The present or future value of money is usually substantial.
A cost seg is not recommended if the property owner will not get better than a 5 to 1 return on investment. Most property owners will proceed if they get more than $5 back for every dollar spent on the study. Most cost segs completed will result in better than a $10 to $1 ratio. If the property owner spent $10,000 on a study, they would achieve between a $75,000 and $150,000 tax deferral. This could enable them to reinvest in their property or to acquire another location.
An entire cost seg study can take from three to eight weeks to complete, with minimal disruption to the building’s activities or work flow. The price tag of the cost segregation study can range from $5,000 to $25,000, depending on the building’s size and tenant count.
“We had a cost segregation study on our property in York Harbor, Maine, the Stageneck Inn,” said Mark Foster, who also owns the Days Inn in Dover, New Hampshire. “When we turned the report over to our accountants, they felt very comfortable with the information provided and applied it to our tax returns. That gave us a fairly sizeable return, which we used to convert a house adjacent to the Stageneck Inn into a furnished rental property. Without the cost seg study, that might not have happened as quickly.”
That’s just one example of how a cost seg study can create cash flow. Obviously, results will vary from property to property. Yet in an economy that’s been particularly difficult for US commercial property owners, cost seg studies provide a legitimate option to improve cash flow so you can keep your property viable and potentially explore areas to enhance the value of that property.
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Jeff Hiatt is the managing member, Performance Business Solutions, LLC (www.revenuebanking.com). Hiatt works with accountants, attorneys, and other experts to determine the best way for clients to reduce costs and increase profits, with a special focus on energy. He’s also on the board of directors of the US Green Building Council (USGBC) New Hampshire Chapter.