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CPA's

Cost Segregation - Overview

Much has been written about "cost segregation studies" (CSS) recently in industry and CPA trade periodicals. So much so that it's now is a widely accepted tax planning strategy for commercial real estate owners.

A cost segregation study is an IRS accepted asset-reclassification procedure that accelerates tax-depreciation deductions. By using this strategy, real estate owners can lower their current income-tax liability and increase current cash flow. Simply put, certain real estate is reclassified from 39-year or 27.5-year depreciable property to shorter-lived (5, 7 and 15-year) property for depreciation purposes. Because the study can recapture available depreciation from prior years, the benefits are substantial.

History

Cost segregation methodology is an offshoot from the "disallowed" component depreciation methodologies used up until the Tax Reform Act of 1986. Numerous real estate owners (landmark case was Hospital Corp of America, HCA) petitioned the tax courts stating that they were required to construct "special use" rooms with special HVAC, electric, etc. systems to run their medical systems and specialty testing instrumentation. In 1997, the Tax Courts ruled in favor of HCA petition which set the stage for allowing qualifying assets to be classified as 5, 7 & 15-year property. Since that time, dozens of additional court cases were decided favorable to this process, allowing many more assets to be reclassified as having a shorter depreciable life.

Cost Segregation Study Process

Our engineers will examine all design and construction documents, contractor payment requisitions and other related data to determine the cost basis for every asset in the building. Next, our engineers will conduct an on-site study to identify, quantify, measure and photograph all assets that may qualify for accelerated depreciation. Further, our team (site engineer, costing engineer and tax specialist) will identify assets that qualify as Specialized Use", i.e. outside normal use of that property type.

Finally, a report is prepared which will contain; a) a narrative section describing the property classes in detail, b) a thorough costing analysis, c) photographs of the assets to validate that an on-site evaluation was conducted and to identify the major assets being rescheduled. The CSS is then provided to the CPA who prepares the IRS forms "Change in Accounting Method" and submits the information to the IRS. This change is automatically accepted by the IRS (presumptive approval) and no amended tax returns are required.

Estimate of Benefits & Savings

The chart below shows a real example of the "Before and After" cost segregation study depreciation allocations. The property in the example below is a hotel having a development cost of $3,440,000 which was built in 1998. The property was improved in 2001 for $375,000. The total depreciable basis for the property is $3,815,000.

As shown above, the study identified the "after CSS" and prior yearly depreciation amounts. The IRS allows a taxpayer to go as far back as 1987 to reclassify property. The benefit to the taxpayer is that the increased depreciation amount from prior years can now be recaptured in the next tax year. The chart below shows the impact of the recaptured amounts:

Results

The graph below shows the property amounts that were originally scheduled as well as those property allocations that were made after the cost segregation study was performed. Prior to the CSS, 39-year property accounted for 100% of the depreciable items. The completed CSS shows that our engineers were able to identify and reallocate $1,793,000 or 47% of the assets to shorter depreciation schedules.

The information below shows the financial impact of the CSS in terms of potential taxes saved. Note: The Cash (tax) savings were determined by using a blended Federal & State tax of 43%. The NPV savings calculation was determined using a 6% discount rate.

Accelerated Property $1,793,050 Additional Depreciation for 2003 $834,279 Cash (tax) savings for 2003 $358,740 NPV over years 1 - 10 $ 431,630

Summary

Cost segregation is now an accepted procedure that years ago had only been available to Fortune 500 companies via the Big 4 accounting firms. Now, CPA firms throughout the nation are knowledgeable of and offering cost segregation studies to clients as an effective means to reduce their taxes. Further, the US Treasury Department seems to be tolerant of accelerated depreciation strategies to reduce taxes as evidenced by favorable rulings that have been issued within the last few years. Most notable was the stimulus packages released relating to accelerated and bonus depreciation. Note: Bonus depreciation is pursuant to the "Job Creation and Workers Assistance Act of 2002" and allows for 30% bonus depreciation on qualified property contracted for and entered into service between September 11, 2001 and December 31, 2004. Bonus depreciation was increased to 50% on qualifying property contracted for and entered into service between May 6, 2003 and December 31, 2004. The "qualified property" is defined as 20-year property or less. Cost Segregation is an appropriate manner to determine assets qualifying as having lives less than 20 years.