Many commercial property owners are missing out on significant tax savings opportunities relating to their real estate investments. While most owners are aware of depreciation benefits, few take full advantage of them. What if you could recover much more of your investment now and free up cash flow to invest in the growth of your business? A cost segregation study is the key to such an opportunity.
What is it and how does it work?
Cost segregation is a tax savings strategy that can provide significant increases in cash flow by deferring income taxes through accelerated depreciation deductions. It is a process of identifying, analyzing and segregating the facility costs into the proper asset classifications and recovery periods. The end result is significantly shorter recovery periods (five-, seven-, 15-year) for many of the property components, instead of the standard 39 years for commercial and 27.5 years for residential properties. This strategy effectively “frontloads” depreciation deductions into the early years of ownership, pushing income tax liabilities out into later years and thus significantly increasing current cash flows. The deferred taxes are essentially an interest-free government loan requiring no payments for a number of years.
Who can benefit?
Owners of most types of commercial buildings, including industrial, office, retail and multi-family, are ideal candidates for a cost segregation study, regardless of whether the facility was constructed, remodeled or acquired yesterday or 15 years ago. A study often can reclassify upwards of 40 percent or more of a building’s cost into shorter recovery periods, depending on the type and use of the facility and the extent of specialized equipment and processes in the building.
Take, for example, the case of a light-industrial facility that was recently acquired for $5 million. Under the standard method of depreciation over 39 years, the owner’s total depreciation deduction over the first five years is $580,000. By segregating out the costs that qualify for shorter recovery periods, the owner is able to depreciate an additional $670,000 over that same five-year period, a tax savings of up to $235,000. Considering the time value of money, the study provides a net present value savings of up to $195,000 over the life of this facility. After all, a dollar in hand today is worth more than a dollar in hand 30 or 40 years from now.
When can it be done?
Cost segregation studies are ideally initiated during the design phase of a new construction project or immediately following the close of a purchased property. A study also can provide significant benefits for older facilities, as long as they were constructed or acquired by the current owner anytime since 1987. Favorable IRS rules and procedures allow taxpayers to perform cost segregation studies on these older facilities and recover all “missed” depreciation expense in the current year. The result can be a significant “catch up” deduction immediately.
Who is qualified to perform the study?
While the benefits can be significant, the process is often complex, requiring the expertise of a qualified cost segregation provider. The IRS requires studies to be conducted by professionals with a thorough knowledge and understanding of the tax law, as well as in-depth experience in construction and engineering. Cost segregation providers work closely with the owner’s tax accountants to ensure results are properly implemented and benefits fully realized.
Additional benefits
The benefits of segregating property components can be enhanced dramatically when coupled with some very favorable tax provisions passed in the wake of 9/11, including 30 percent and 50 percent bonus depreciation, 15-year qualified leasehold improvement property and 15-year qualified restaurant property. Even though bonus depreciation expired at the end of 2004, taxpayers can still recover missed prior-year opportunities, as mentioned above. The 15-year qualified property rules are currently set to expire at the end of 2007.
Cost segregation studies can provide state and local tax benefits as well, including sales tax exemptions and reduced property tax assessments.
Most properties held for business use are eligible for cost segregation; however, the available benefits vary depending on the property type and an owner’s tax situation. Tax advisers should be consulted to help determine whether or not a cost segregation study is beneficial.
Robert Grannum is a certified public accountant who specializes in cost segregation services at Moss Adams LLP. He is director of the firm’s Western Washington Cost Segregation Services group, leading a team of engineers and accountants who provide in-depth studies in cost segregation and related tax matters. Grannum can be contacted at 425-303-3003 or by sending e-mail to robert.grannum@mossadams.com. For more information, go online to www.mossadams.com/services/tax/costseg.htm.
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