Cost Segregation Studies
Most owners of developed real estate can benefit from a Cost Segregation Study (CSS). This IRS sanctioned "engineering-based" procedure provides taxpayers the necessary support to reclassify improvements to immediately shorter recovery periods. This reclassification increases the depreciation deduction now. It can be used on new construction, existing construction, tenant improvements, and properties that have been in service for many years without the need to amend tax returns.
Real estate improvements are usually depreciated using a straight-line method over 27.5 years (residential) or 39 years for commercial properties. However, certain improvements can be depreciated over 5, 7, or 15 years.
A CSS identifies these shorter-lived components, allowing them to be depreciated over a shorter period. This "front-loading" of the depreciation deduction helps reduce taxes immediately.
How much money can be saved?
The amount of savings depends on the type of property and its construction, but most property types derive significant benefits. In many cases, a ballpark after-tax savings of 10% of an asset's depreciable basis can be realized over the first 10 years. However, it is not unusual to experience after-tax savings as high as 15% for buildings with extensive personal property improvements.
What type of properties are good candidates?
While every property type, excluding a personal residence, can provide some tax-benefits through a CSS, certain properties benefit more due to the specific nature of their components. Generally, the more specialized and function-dedicated a property is, the greater the benefit derived from a CSS re-classification.
Manufacturing facilities, hotels and resorts, restaurants, professional offices, and high-end retail are generally good CSS candidates. However, properties with extensive site preparation work and tangible personal property such as: big-box retailers, warehousing and distribution centers, self-storage facilities, and multi-family buildings are also excellent candidates for a CSS.
Is your property a candidate?
If you can answer "yes" to the following questions, a CSS will save you money.
- Did you construct, acquire, renovate or improve (including tenant work) the property after 1986? Is it currently under construction or in the planning stage?
- Do you expect to own the property for at least 3 years?
- Does the property have a positive cash flow? Could additional depreciation help offset other tax liabilities?
- Is the depreciable basis greater than $500,000?
Financial Benefits
The financial benefits vary, but can be substantial, as the following table illustrates.
Value of $100,000 of Depreciable Costs Re-Classified:
Property Life Categories |
|||
5-Year |
7-Year |
15-Year |
|
First Year's Increase in Depreciation |
$18,700 |
$13,000 |
$3,700 |
First Year's After-Tax (35%) Benefit |
$6,300 |
$4,400 |
$1,200 |
NPV at 8% of After-Tax Benefit: Years 1 to 10 |
$23,900 |
$22,200 |
$11,300 |
NPV at 8% After-Tax Benefit: Years 1 to 39 |
$19,000 |
$17,400 |
$10,700 |
When do you realize the savings?
Your tax professional is in the best position to determine the timing of the tax benefit. However, the benefit can only be realized if the Taxpayer can utilize the additional deductions.
What if I am not taking advantage of Cost Segregation?
The IRS encourages taxpayers to record depreciation correctly. To this end, the IRS allows Taxpayers that are not in compliance with the guidelines to utilize the Application for Change in Accounting Method (Form 3115) to automatically change the lives of real and personal property improvements. The difference between the depreciation recorded incorrectly versus the correct amount is known as catch-up depreciation. Catch-up depreciation is a one time adjustment that can significantly reduce or wipe-out taxes for the current year.
CCR's Engineering-Based Approach
A convergence of professional skills - including engineering and accounting - make a CSS successful. The IRS requires an engineering-based approach be employed to identify and re-classify construction costs into applicable segregated categories. A simple review of contractor payment requisitions to identify qualifying components for re-classification is generally not enough to satisfy IRS scrutiny. Our CSSs follow the American Society of Cost Segregation Professionals technical standards. (www.ascsp.org)
A successful CSS requires the following engineer-based procedures:
- a detailed analysis of the direct and indirect construction costs;
- an examination of available drawings and specifications;
- a physical inspection to observe and identify component utilization;
- an engineering perspective of specific building, mechanical, and electrical systems, as well as manufacturing processes; and
- a detailed knowledge of the tax code as it applies to the cost seg process combined with the analytical abilities and organizational skills to conduct the necessary economic and financial analysis.
These are all CCR core strengths. Our CSSs are thorough and well documented with a paper trail that accounts for all construction component re-classifications.