Cost segregation studies are an effective component of any cash management strategy for a business that owns buildings or other depreciable real property for business use. The strategy involves the deferral of income tax liabilities to later years through the identification of property having a shorter cost recovery period for federal income taxes, which even the IRS acknowledges as an appropriate deferral method.
Smart Business spoke with Walter McGrail, senior manager at Cendrowski Corporate Advisors LLC about using cost segregation.
Why are cost segregation studies effective?
The benefit is the ‘present value savings’ attributable to the deferral of federal and state income taxes. The actual savings is the reduction in current tax payments now, with resulting increases in taxes payable in subsequent periods, i.e., the ‘time value of money’ attributable to tax deferral. As with any treasury cash management program, a property owner’s cost of capital is typically the appropriate discount rate to measure the ‘present value savings’ of deferring cash charges for income taxes.
How does it work?
First, cost segregation studies identify categories of costs that have a shorter cost recovery period for income tax purposes. Buildings typically have a depreciable life of either 27 or 39 years, while the depreciable lives of furniture and fixtures ranges from five to seven years. Though the total amount of cost recovered is the same regardless of the recovery period, the shorter it is, the sooner the resulting tax savings occurs.
Second, shorter life property generally qualifies for accelerated depreciation methods. Buildings are depreciated under the straight line method, which results in the same depreciation expense during each year the building is owned. Shorter recovery life property identified in a cost segregation study may be depreciated under accelerated cost recovery methods. For example, depreciating property with a five year life using accelerated depreciation on the same five year property results in more than 70 percent of the cost being depreciated during the first three-year period. There are also new Treasury regulations that permit immediate deduction of qualified repair costs. The professional conducting the cost segregation study will be able to apply the new expensing regulations, as well. The tax savings occurs for both federal and state income taxes. Current federal corporate income tax rates are 35 percent and states’ are typically are around 5 percent.
How is a cost segregation study conducted?
Studies must be properly conducted to withstand IRS scrutiny, which requires not only professionals trained in the proper classification of assets for federal depreciation purposes but also personnel with engineering and construction experience to properly classify the components of a structure. Key to a successful audit defense are documentation of findings and expert personnel.
What businesses might benefit from this?
Cost segregation studies can be conducted on new construction, rehabs, recently purchased properties, or even properties held for a period of years. For newly constructed property, and to some extent rehabilitated properties, shorter life depreciable property may qualify for bonus depreciation. Bonus depreciation rules permit a first year depreciation deduction equal to 50 percent of the cost of identified qualifying property. Bonus depreciation and more favorable capital expenditure expensing elections will expire after 2012.
What is the time frame to conduct a study?
In order to make a claim for the 2012 calendar year, the study must be conducted before the extended due date of the 2012 returns, typically Sept. 15, 2013. Sufficient time should also be permitted to coordinate the findings of the study with the business’s preparation of its 2012 income tax returns. For properties owned prior to 2012, the IRS has provided a relatively straightforward means to claim the resulting difference in depreciation expense before and after the study is conducted.
Walter McGrail is a senior manager at Cendrowski Corporate Advisors LLC. Reach him at (866) 717-1607 or email@example.com
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Are you getting the most that you can out of your property? If you’re not using cost segregation — a little-known method to accelerate tax deduction applied to capitalized costs for many property owners and lessees — you may be missing out.
Scott Smith, an associate in the Tax Solutions Group of Plante Moran an affiliate of Plante Moran CRESA, says that this technique is often overlooked during the construction and acquisition of property, but in both of those transactions, it could provide immediate cash benefits.
“Using cost segregation as part of your planning can potentially free up money to do more on your project or to get back on budget,” Smith says.
In many cases, 10 to 30 percent of a building’s cost can be reclassified into shorter-lived asset classes, such as personal property and land improvements. These asset classes have significantly shorter depreciable lives than that of the building itself, allowing for faster write-offs than would normally be available by classifying the building as one item.
Smart Business spoke with Smith about how to apply cost segregation and the benefits you can realize by doing so.
What is cost segregation?
Cost segregation is the process of taking capitalized costs that generally depreciate over decades and doing a detailed engineering study that fully utilizes IRS laws and rules that allow you to accelerate depreciation. A cost segregation professional who is familiar with construction and the tax laws will apply the facts and circumstances to any given facility to maximize the benefit to the property owner.
What are the benefits to undertaking such a study?
Many property owners will put an entire property on their fixed asset schedule as a single line item and, as such, it will depreciate uniformly over time. Cost segregation takes the depreciation that would normally accrue over 39 or 27.5 years and makes it available to be depreciated between five and 15 years. This creates a net present value that frees up money for the taxpayer to do things such as expand the business, fund future projects and buy new furniture.
For example, reclassifying $100,000 in assets from 39-year property to five-year property will result in approximately $19,000 in net present value savings, assuming a 6 percent discount rate and a 40 percent composite tax rate.
What assets can cost segregation apply to?
In an office setting, it can apply to items such as carpeting, wallpaper, decorative lighting and cabinetry. In manufacturing, assets such as process electrical, process piping and HVAC, and equipment foundations should be considered. The depreciable life on these assets is generally five or seven years.
On the outside of a building, look at land improvements such as parking lots, site lighting, landscaping, retaining walls, sidewalks, curbs and gutters. The depreciable life on these assets is generally 15 years.
What types of companies should consider cost segregation?
It is beneficial for companies that have built, renovated or acquired a facility and need to offset some of their income — really, any company that has to capitalize costs that it has paid for. In general, the value of the construction or acquisition should be in excess of $1 million to feel the benefit from a cost segregation study. Companies can even go back in time. Say, for example, you purchased a building in 2006 and put it on your fixed asset schedule. Provided that the documentation and records are good, you can do a cost segregation study in the current year and ‘catch up’ any missed depreciation, all the way back to 2006, in the same year. This missed depreciation is called a 481(a) adjustment and can be claimed by filing the proper paperwork without having to amend any prior tax returns.
When is it a good time to do cost segregation?
The best time to do it is right after you buy, renovate or construct property, for several reasons. The documentation at that time is readily available and not collecting dust in a box somewhere. Also, the people associated with the construction are still available and information is fresh, which ultimately increases the quality of the study because fewer assumptions need to be made.
Who should conduct the study?
Choose someone who’s reputable and qualified. The IRS has issued an Audit Technique Guide that serves as an outline of what a quality cost segregation study includes and who is most capable of doing it.
If you use the wrong person — someone who is not familiar with tax law or construction — that person might not provide the detail that you need to pass an IRS audit if one should occur, which could result in interest and penalties. Make sure that you’re working with someone who understands both engineering and tax law to ensure that you get good results.
Why should companies take advantage of this opportunity now?
For certain years, the IRS has said that not only can you accelerate depreciation through cost segregation, you can also qualify for substantial bonus depreciation in the first year on new property. This year, the rate is 50 percent, which means that you’ll accelerate the depreciation on half of a qualifying item’s value, in addition to the percentage you would normally get in the first year. Imagine depreciating more than half of your new carpeting or parking lot in the first year. If you constructed property in 2011, the rate is an unprecedented 100 percent.
Businesses should take advantage of this opportunity now, as it is currently set to expire at the end of this year.
Scott Smith, LEED AP, is an associate in the Tax Solutions Group for Plante Moran, an affiliate of Plante Moran CRESA. Reach him at (248) 603-5203 or firstname.lastname@example.org.
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Now is the time to seriously consider how you classify real estate expenditures, including building purchases, major renovations, tenant improvements and smaller projects such as acquiring fixtures.
In the current tax environment, there may be an opportunity for your business to turn slowly depreciating cash expenditures (tax write-offs) into tax-deductible items that can be fully depreciated in one year. The result is a lower tax payment in the current year.
The key to claiming this benefit is to reclassify costs by unraveling items from your overall real estate investment. Then, you can identify which of those costs qualify for accelerated depreciation. The process is called a cost segregation study, and any business with real estate expenditures should consider having one done.
“Now more than ever, it’s important to save on real estate and construction project costs. One of the ways to do that is to realize available tax benefits,” says Cathy Goldsticker, member, tax services, Brown Smith Wallace LLC, St. Louis, Mo.
Many businesses are not aware of the tax benefits that a cost segregation study can uncover. And as tax planning season closes in, now is a good time for your business to discuss this opportunity with a CPA who has experience performing cost segregation studies.
“With this bonus depreciation tax law scheduled to expire at the end of fiscal 2011, we can’t be certain there will be an extension of this tax benefit, so businesses should consider how they can take advantage of this remarkable write-off,” says Nick Lombardi, manager of risk services and energy services practice leader, Brown Smith Wallace.
Smart Business spoke with Goldsticker and Lombardi about how cost segregation studies work, how they benefit companies and what your business can do to act on this opportunity now.
What is a cost segregation study?
A cost segregation study involves moving portions of property development from long-tax-life assets to shorter-life schedules. Essentially, cost segregation is a tax planning strategy that allows businesses to accelerate deductions and defer tax payments for real estate expenditures, which include land improvements, furniture and equipment.
Items are unraveled from the total asset cost and assigned an individual cost amount. Qualifying items can be depreciated separately and many times more quickly. For example, you could depreciate decorative lighting or furniture 100 percent in the current year, when, historically, a typical real estate depreciation tax write-off schedule for commercial property is 39 years. Many times, costs can be reclassified from ‘land,’ a nondepreciatable asset, to classifications that will provide an immediate tax benefit. Accelerated tax write-off schedules are a tremendous benefit for businesses. Engaging in a cost segregation study can tease out those qualifying expenses.
What does a cost segregation study involve?
It requires formal documentation of the cost basis — the real estate expenditures that are being depreciated — and a reliable method for depreciating those assets on the accelerated schedule that allows 100 percent depreciation over one year. The process includes observation, pictures, measurements and an engineering analysis to determine which items can be unraveled from your real estate expense. The study involves a present value analysis that details how much qualifying items are worth, a mathematical analysis and the application of tax law. A team of professionals, including an experienced accountant and an engineer who specializes in cost segregation studies, is important to ensure that proper documentation is compiled to support the shorter-term depreciation schedule. While the process seems complicated — and it does involve many moving parts — cost segregation studies are quite efficient when professionals have the resources to perform them effectively. A study can take as little as four to six weeks to complete, and, considering the potential tax benefit, the time is well spent.
When does it make sense to hire a professional to perform a cost segregation study?
Any business that has made a land improvement or purchased furniture or equipment in the last several years might be a candidate for a cost segregation study. And don’t discount smaller projects. The cost of performing a study is less when the project scope is smaller, so there is a benefit to engaging in a study for less complex real estate endeavors.
How can a cost segregation study directly benefit a business?
For one, faster depreciation on tax-deductible items frees up cash flow for a business. This is critical, especially now when so many companies are struggling to maintain a healthy cash flow. Cost segregation allows a business to maximize bonus depreciation or the depreciation of qualified leasehold improvements. These studies can be done at any time, with benefits realized very quickly. The study can be retroactive, meaning projects completed, or qualifying purchases made in the past several years, can be re-examined and costs segregated to take advantage of this tax benefit. Talk to your tax professional about lookbacks and projects that you’ve completed in the past one to four years that could warrant a cost segregation study.
How can a business prepare for a cost segregation study?
Proper, specific documentation is critical, which is why hiring a professional who specializes in cost segregation studies is crucial. This person will create the documentation to support the rationale for depreciating items in a much more efficient manner for tax purposes. So when preparing for a study, ask the professional about the process, find out if there is a specialized engineer on staff to help and be prepared to assist with the documentation process, including taking pictures and measurements to create the necessary documentation. The process is seamless, and it doesn’t take long to realize potential savings of thousands of dollars.