Big Tax Savings Now More Than Ever for Investors in Real Estate

Whether a real estate investor is constructing, purchasing or expanding a building, a cost segregation study can significantly increase cash flow by accelerating tax deductions. A study can also be applicable to past purchases, expansions, renovations, leasehold improvements and to the step-up in basis of property currently owned. Numerous tax acts beginning in 2002 have created a tremendous opportunity for real estate investors to increase cash flow significantly. In a tough real estate market the ramifications of a cost segregation study and the potential tax savings and resulting cash flow increase should be taken into account when negotiating a deal. The landlord may be willing to pay for more of the tenant improvements if the costs can be amortized over 5, 7 or 15 years instead of 39 years for commercial property or 27 ½ years for residential property. A study may just be the competitive edge the landlord (or tenant?) needs to make the deal!!

ADDITIONAL INCENTIVE FOR ASSETS ACQUIRED AFTER SEPTEMBER 10, 2001

  • With the passage of the numerous Acts noted above the incentive to do a cost segregation study is greatly expanded. The tax acts allow a 30%, 50% or 100% additional first year bonus depreciation deduction for certain new acquisitions. Additionally, under the 2003 Act and subsequent Acts the Section 179 expense election is significantly expanded.
  • While most real estate costs do not qualify for the first-year bonus 30%/50% depreciation deduction, a cost segregation study can identify costs that will qualify. In a large building project the result can be significant.
  • This 30%/50%/100% provision enables business owners to recover more of the cost of a business asset upfront. For example, a business constructs and places in service a new building in 2011 and a cost segregation study determines that $100,000 of the cost can be treated as 5 year propertyThis 5 year property is eligible for 100% bonus depreciation and the first-year write off under this new law is $100,000. Under prior law, the maximum firstyear write off is only $20,000 (20%). (Note: this does not take into account the expensing deduction that may be allowable under IRC Section 179 – see below). If a cost segregation study is not done to document this as 5 year property, it would remain as part of the 39 year real property with a maximum depreciation of $2,564 claimed in the first-year.
  • Under Section 179 of the tax code small businesses may expense up to $500,000 of qualifying property placed in service for some tax years. The dollar amount is phased out dollar-fordollar as the taxpayer’s cost of qualifying property for the year exceed $2,000,000. These dollar amounts have been adjusted for inflation and were increased over time from 2001 through 2014. A cost segregation study will determine what property in a commercial (NOT residential) project will qualify for the Section 179 expense deduction.
  • In addition, various tax acts have identified other qualified improvement property:
    • Qualified Leasehold Improvements
    • Qualified Restaurant Improvements
    • Qualified Retail Improvements
    • All of these types of improvements under current law qualify for some or all of the tax benefits we have discussed previously.
  • Lastly, in December 2011 the Internal Revenue Service released new regulations commonly referred to as the “Tangible Personal Property” regulations. These regulations provide guidance on when to expense or capitalize major repairs and improvements to an asset. A properly documented cost segregation study can assist you in identifying the undepreciated portion of a replaced piece of property such as a new roof, windows or other building systems.

HOW DOES A COST SEGREGATION STUDY DECREASE TAXES?

A cost segregation study:

  • Carefully breaks down construction and/or acquisition costs and allocates them to specific asset categories, maximizing depreciation expense for qualifying costs.
  • Utilizes engineering and architectural reports to determine what portions of systems installed in a building are not related to building operation and maintenance and are, therefore, Internal Revenue Section 1245 property. Section 1245 property is eligible for much faster depreciation (e.g. 5, or 7 years instead of 27 1/2 or 39 years). The following are some examples of property that MAY include some costs that qualify as Section 1245 property:
    • Electrical Distributions Systems
    • Air handling and safety
    • Carpeting
    • HVAC and air conditioning units
    • Lighting, interior and exterior
    • Partitions and walls
    • Plumbing and wiring
    • Site utilities
    • Additionally, site work (site improvements, parking lots, landscaping) generally qualifies as 15 year property.
  • Increases cash flow – The benefits of a cost segregation study can far outweigh the up-front cost. Whether constructing, purchasing, or expanding a building, a cost segregation study can significantly increase cash flow by maximizing depreciation.
  • Can also apply to past purchases, which means that adjustments for “missed” depreciation deductions from prior years can be reported as an automatic change in accounting method and deducted 100% in the year of the change.
  • Can recognize and compute costs that are hidden in the normal 27 ½ or 39 year depreciation classes, but in fact qualify for accelerated depreciation. Analysis of blueprints and specifications, property inspections, allocation of costs to asset categories and allocation of indirect costs are a few of the aspects involved in a thorough cost segregation study.
  • Must be done by experts, including qualified and experienced appraisers, architects, engineers and tax professionals who should be brought in when a building is bought, built, renovated or expanded.
  • Should be thorough, well documented and supported with relevant information in order to withstand an IRS audit. A thorough cost segregation study may not be based on non-contemporaneous records, reconstructed data, or taxpayer’s estimates or assumptions that have no supporting records.

THE LAW AND COST SEGREGATION

The determination of whether an asset is a structural component or tangible personal property depends on its primary use and each determination should be evaluated on a case-by-case basis.

  • Based on Health Corp. of America v. Commissioner, 109 T.C. 21 (1997) (“HCA”), as well as other relevant cases and IRS positions, there is authoritative guidance supporting the classification of items as either tangible personal property or structural components. It also appears clear that identifying a property’s primary use plays a significant role in determining the proper asset class and depreciable recovery period. For example, in HCA the Tax Court concluded the taxpayer could depreciate over 5 years that percentage of the electrical systems, measured by electrical load, allocable to hospital equipment as opposed to building operation or maintenance.
  • The Tax Court’s conclusions have significant relevance to commercial property owners. For example, if a building is built for a restaurant operation, that part of the cost of its electrical distribution system allocable to the restaurant’s operation – e.g. refrigerators, freezers, etc. – would be eligible for 5 year accelerated depreciation.

Although a cost segregation study is ALWAYS beneficial, the impact of a study following the passage of various Acts since 2001, to properly allocate assets and depreciate them over a shorter depreciable life is astounding and creates an opportunity “not to be missed” for real estate investors.

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