Cost segregation studies can help you maximize tax savings and increase cash flows on your current, future or past property purchases by maximizing tax deferrals.
“Almost anyone with an interest in real property whether an owner or a tenant should consider having a cost segregation study conducted,” says Walter M. McGrail, JD, CPA, senior manager at Cendrowski Selecky PC. “Hundreds of thousands of dollars may stand to be achieved.”
Under IRS guidelines, the depreciable tax life of most commercial buildings is 39 years. Accelerated methods can be used to reduce the recovery periods for personal property and land improvements to five or seven and 15 years. A cost segregation study identifies items that can be classified properly into categories with shorter lives.
Smart Business asked McGrail about the benefits of having a cost segregation study conducted.
What is the goal of a cost segregation study?
A cost segregation study is an analysis of the costs a taxpayer has in real property in order to break out the costs attributable into shorter recovery periods for federal and state tax purposes. The benefit is accelerated tax deductions by recovering the costs over five, seven or 15 years, versus 39 years. Depending on how personal and real property is taxed in the locale where the building is located, there can be significant property tax savings, as well.
Eligible properties include new buildings under construction, existing property that was purchased recently or soon will be, and existing property that was purchased after 1986 (the IRS allows for catch-up for foregone savings). It doesn’t matter what the use of the building is; industrial, retail, commercial/office, health care facilities or even residential rental housing qualifies.
How much can be saved?
In general, it depends on three factors: the cost to acquire the building, the money you are going to put into it and how you are going to use the property. It is not inaccurate to say that you could save several hundreds of thousands of dollars. For example, if you spent $10 million on a building, you might save $250,000 to $1 million on a present value basis. We usually see a greater percentage of savings with retail, office and hotel space.
What happens during the process?
There are several phases to the cost segregation study. During the bid phase, the engineering professionals and tax accountants walk through all areas of the property with a site representative to develop a general overview. If granted the engagement, the firm’s engineers examine the architectural renderings or blueprints to produce an in-depth analysis. Next, the tax accountants take the engineers’ work and put it in format acceptable to the IRS. A report with documentation supports how the cost recovery was arrived at. During the process, the firm should examine the purchase agreement to see if it contains any stipulations on allocations. Many times, during the 11th hour of negotiations, the parties will invite their tax professionals in, and the accountants end up allocating part of the purchase price. Quite often we find something. For example, say the building sold for $10 million, but a stipulation specified that $1 million had to be allocated to good will. So you have to be careful stipulations need to be identified and honored.
Are there situations where a cost segregation study would not make sense?
It takes about five to seven years to start recouping the tax savings, so you may not realize the payback period if you plan to sell the property in short order. There may also be challenges down the road if you try to use the building for a tax-free swap, and you’ve already identified personal property through the cost segregation study. In any case, a professional can review the options with you. Every situation is different.
Any final words of advice?
Look at the level of expertise offered by the firm that will do the study. A cost segregation study is not done in a vacuum it represents the marriage of an engineer’s viewpoint with the costs involved with a property. The work needs to be integrated, and the team of engineers and tax professionals must be highly experienced and work well together. You might also want to consider what types of incentives the firm has. Larger or more experienced firms might offer contingencies. For example, they might produce the study for a fixed fee plus a percentage of the tax savings recovered for you.