February 23, 2006
Author: , CPA, MST
Significantly increasing cash flow, a cost segregation study accelerates tax deductions for real estate investors constructing, purchasing, or renovating a building throughout the United States including Maryland.
In a tough real estate market, a cost segregation study, the potential tax savings, and resulting cash flow increase should be taken into account when negotiating a deal. A study may just be the competitive edge the landlord or tenant needs to make the deal!
ADDITIONAL INCENTIVE FOR ASSET ACQUISITIONS PER 2002 & 2003 TAX ACTS
Expanding incentives to do a cost segregation study, the 2002 and 2003 Acts allow a 30% or 50% additional first year bonus depreciation deduction for certain new acquisitions.
- The 30% rate applies to acquisitions after September 10, 2001 and before January 1, 2005. The 50% rate applies to acquisitions after May 5, 2003 and before January 1, 2005. Property under construction before January 1, 2005 but placed in service after that date may also qualify for this bonus depreciation.
- A study done currently on assets acquired in the above time periods can take advantage of bonus depreciation that was missed.
- While most real estate costs do not qualify for the first-year bonus 30%/50% depreciation deduction, a cost segregation study can identify costs that will qualify. In a large building project the result can be significant.
- This 30%/50% provision enables business owners to recover more of the cost of a business asset upfront.
Under Section 179 of the tax code, small businesses may expense up to $100,000 of qualifying property placed in service for tax years beginning in 2003 through 2007. The dollar amount is phased out dollar-for-dollar as the taxpayer’s cost of qualifying property for the year exceed $400,000. These dollar amounts will be adjusted for inflation and were increased from a $25,000 expense/$200,000 cost. A cost segregation study will determine what property in a commercial (NOT residential) project will qualify for the Section 179 expense deduction.
HOW DOES A COST SEGREGATION STUDY DECREASE TAXES?
A cost segregation study:
- Carefully breaks down construction and/or acquisition costs and allocates them to specific asset categories, maximizing depreciation expense for qualifying costs.
- Utilizes engineering and architectural reports to determine what portions of systems installed in a building are not related to building operation and maintenance and are, therefore, Internal Revenue Section 1245 property. Section 1245 property is eligible for much faster depreciation (e.g. 5, or 7 years instead of 27 1/2 or 39 years). The following are some examples of property that MAY include some costs that qualify as Section 1245 property:
Electrical Distribution Systems
Air handling and safety
HVAC and air conditioning units
Lighting, interior and exterior
Partitions and walls
Plumbing and wiring
Additionally, site work (site improvements, parking lots, landscaping) generally qualifies as 15 year property.
- Increases cash flow by maximizing depreciation, outweighing the up-front cost.
Can also apply to past purchases or costs, which means that adjustments for “missed” depreciation deductions from prior years can be reported as an automatic change in accounting method and deducted 100% in the year of the change.
- Can recognize and compute costs that are hidden in the normal 27½ or 39 year depreciation classes, but in fact qualify for accelerated depreciation. Analysis of blueprints and specifications, property inspections, allocation of costs to asset categories, and allocation of indirect costs are a few of the aspects involved.
- Must be done by experts, including qualified and experienced appraisers, architects, engineers, and tax professionals who should be brought in when a building is bought, built, renovated, or expanded.
- Should be thorough, well documented, and supported with relevant information in order to withstand an IRS audit. A thorough cost segregation study may not be based on non-contemporaneous records, reconstructed data, or taxpayer’s estimates or assumptions that have no supporting records.
The determination of whether an asset is a structural component or tangible personal property depends on its primary use and each determination should be evaluated on a case-by-case basis.
The impact of a cost segregation study, to properly allocate assets and depreciate them over a shorter depreciable life, is astounding, creating an opportunity "not to be missed" for real estate investors.
Jane M. Brewer, CPA, MST, is a shareholder with the accounting firm of KAWG&F, P.A. and the co-chair of the firm’s tax department. She welcomes the opportunity to hear from you. For more information on cost segregation studies, or to arrange an appointment to discuss your project, contact Jane at 410-828-CPAS or e-mail [email protected]