Greg Francis, CPA August 1, 2006

Imagine being able to save over $25,000 per year on taxes simply because you own an apartment building.

 Imagine being able to save over $25,000 per year on taxes simply because you own an apartment building. Every year taxes leave a bitter taste in many taxpayers’ mouth; however cost segregation could save apartment owners a lot of money. Let’s look at an example: John just constructed a $2.2 million apartment building and placed it in service in 2005. After conducting a cost segregation study, he took a $100,000 depreciation deduction in the first tax year and will continue to take between $100,000 and $175,000 every year for the next four years. Sounds too good to be true? Not with a cost segregation study.

What is a cost segregation study?

Cost Segregation is a strategic tax saving tool that allows taxpayers who own any kind of real estate to increase cash flow by accelerating depreciation deductions and deferring income taxes. 

           Using a cost segregation study, certain building or improvement costs are identified, segregated, and reclassified into shorter depreciable tax lives for federal and state income tax purposes (i.e. 5-and 7-year personal property and 15-year land improvements verses 27.5-year or 39-year real property).

To put this into general terms, consider John’s situation.  Construction costs include appliances, carpeting, certain air conditioning units, vinyl flooring, kitchen sinks, countertops, and more, all of which may be considered personal property for tax purposes (depreciable over five or seven years). Additionally, most exterior improvements such swimming pools, landscaping, parking lots, walkways also qualify for accelerated deductions (depreciable over 15 years). A study will identify, quantify, and then value these items in the form of a detailed engineering report.  The report will then categorize each construction component into its most tax efficient category for depreciation purposes yielding big deductions for owners.

Ideally, a cost segregation study should be completed during the year the building is placed in service, acquired, or remodeled. However, a study can be completed anytime thereafter.  In fact, current Internal Revenue Service procedures make it easy to go back and claim accelerated depreciation on assets acquired, remodeled, or constructed as far back as 1987, without amending prior tax returns. So any missed depreciation deductions from prior years, can be claimed in the current tax year when a study is conducted.

A study does not create more depreciation deductions.  Over a period of 27.5 years the same tax is paid, but it allows an investor to take those deductions sooner.  If a cost segregation study is not done you are essentially pre-paying your taxes and any savvy investor knows that there is huge value in deferring taxes.  Considering our example and the present value of money (Present Value Factor of 8%, and a combined Federal and State tax rate of 41%) the total net present value of accelerating deductions and cash flow is over $75,000.

It is important to note that because of the recapture tax associated with accelerated depreciation deductions when selling a building, a cost segregation study is recommended for owners who plan on holding a property for generally longer than three years, unless an owner plans to exchange.  Cost Segregation also works great when combined with a 1031 exchange.

 

How does the IRS feel about CS?

While many fortune 500 companies have been using Cost Segregation for years, only recently has this tax strategy gained popularity amongst middle market taxpayers. The main reason for the growing interest in this area is due to the favorable developments regarding the IRS’s stance on cost segregation.  The most recent validation of this technique includes the landmark case: Hospital Corporation of America vs. Commissioner (1997-1999). In this case, HCA used cost segregation studies and argued that many components of its buildings such as handrails, vinyl floor covering, carpeting, and others are not innately structural components of the building, thus should be assigned to different class lives. The tax court ruled in favor of HCA.  As a result, the IRS decided that they would not contest the use of these studies anymore.

          Since HCA, the IRS issued numerous documents supporting the studies. Most notably, the IRS Cost Segregation Audit Techniques Guide (2005) is now used as the backbone for quality cost segregation studies. 

Who does this?
 

The IRS wants to see cost segregation studies done by engineers since they are most qualified to determine how building components are constructed and used.  Because of the specialized knowledge needed, the IRS requires a cost segregation study to be performed by a qualified independent third party. Although many CPAs are not equipped to conduct these studies, it is always important to keep your CPA in the loop when considering a study since the results will impact your overall tax situation. 

 

Strategies Using Cost Segregation

          Cost segregation can be a powerful tool in and of itself, however in conjunction with other tax planning strategies, the benefits can be huge. 

Estate Tax Planning: Cost Segregation within Estate Tax Planning creates “free money” by accelerating depreciation on the same property multiple times. In a community property state such as California, a family can take accelerated depreciation on the same short life assets up to three times by having a Study performed while both spouses are alive, after the first spouse is deceased, and after the second spouse is deceased.  

Lease Provisions Tenant Improvements: When a tenant enters into a lease agreement and receives allowances for improvements from the landlord, it is important to address which costs the improvements are covering. A landlord will want to allocate the allowances to shorter-lived assets whereas a tenant will want the allowances allocated to structural components (so that out of pocket costs go to pay for shorter lived assets).

Like-Kind (1031) Exchanges: By either conducting a Look-Back Study on the old property, or performing a Study on the acquired property, a taxpayer can create additional tax deductions that create an opportunity to take cash out of an exchanged property while mitigating the impact of the income created by the “boot.”

          Passive losses, net-operating losses, Bonus Depreciation, and others also create fruitful scenarios for Cost Segregation. We highly recommend you discuss these with your tax advisor to see what is appropriate for your situation.  Regardless of your circumstance, chances are if you are paying income taxes, a cost segregation study will help.

This article is intended to provide general information only, and does not represent any specific tax advice regarding any individual or company’s unique tax situation. In no way does this article represent financial advice. For assistance in your own situation, please seek the counsel of your tax and/or financial advisor.