What is Cost Segregation?
Cost Segregation is a strategic tax savings tool that allows companies and individuals who have constructed, purchased, expanded, or remodeled real estate to increase their cash flow by accelerating depreciation deductions and deferring their federal and state income taxes.
The goal of a Cost Segregation study is to identify, segregate, and reclassify project-related costs that are currently classified as real property to shorter depreciable tax lives for federal and state income tax purposes. Recent IRS rulings and procedures have allowed taxpayers to change accounting methods to take advantage of these previously understated depreciation expenses – back to 1987. This is done without amending tax returns.
Cost Segregation started in the 1960’s and has been called component depreciation studies, investment tax credit studies and various other names. No matter what name you use — Cost Segregation can save you tax dollars and increase your cash flow. There are over 300 court cases and I.R.S. rulings supporting the benefits of Cost Segregation. The following is an example.
Hospital Corporation of America v Comm. 109 TC 21 (1997) ruled that certain assets associated with a specific piece of equipment not linked to the normal operation and maintenance of the building qualify for five-year depreciable tax lives instead of 39-year depreciable tax lives.
Essentially, the tax courts and IRS have agreed that the taxpayer can use a Cost Segregation study to segregate the cost of
Is Cost Segregation Important?
Cost Segregation is extremely important due to the complexities of our tax laws. Tax laws provide numerous asset lives and categories that may be applicable to various building projects. Taxpayers and accountants often do not understand how to apply these tax rules. Normally, they depreciate the entire building cost over 39 years. At the time of construction the general contractor provides you with a monthly draw request. In this draw request the contractor combines different construction costs into single line item categories.
These categories are made up of numerous components. For example the electrical contract might have light fixtures, panel boards, and conduit buried within a single line item. When the building is completed your project-related construction costs are sent to your accountants so they can prepare your depreciation schedules and tax returns. Because the contractor did not break out the different components of the building, your accountant is hard-pressed to identify the various components of the building. Therefore, the entire project-related construction costs are placed in a 39-year (non-residential real property) tax life. A Cost Segregation study can identify, segregate, and reclassify these components into a shorter depreciable tax life.
When Should I Begin?
The ideal time to begin a Cost Segregation study is when plans are drafted to purchase, construct, expand or remodel a building. If possible, the study should be completed in the year the building is placed in service. However, a Cost Segregation study can be performed on any property as far back as 1987. Recent IRS procedures make it easier for you to reclassify your assets without amending prior tax returns. You can recapture all of the understated depreciation expense for any asset that has been improperly classified in previous years. For example: You placed an asset in service in 1990. Its original basis was $100,000. The tax life you gave this asset was 31.5 years and the depreciation method was straight-line. This asset has depreciated 60% over 20 years. The remaining basis of this asset is $40,000. The correct life of this asset should have been 5 years. The IRS states that if you have truly made an error in the classification of an asset — as in this case — you can make a correction to this asset without being penalized. Therefore, you can bring forward the understated depreciation expense of $40,000 (remaining basis) in the year that you are correcting the misclassified asset. According to the IRS, the full amount of the understated depreciation expense deduction (remaining basis) can be claimed on your tax return in the year of change.
What Types of Buildings Qualify?
The photographs above show several types of buildings that would benefit from a cost segregation study. It also represents typical percentages of project-related costs that can be reclassified from 27.5/39-year (real property) to 15-year (land improvements) or to 5-or 7-year (personal property) for each building type. Additional examples are automobile/truck dealerships, convenience stores, car washes, gas stations, shopping malls/strip centers, fitness centers/sporting facilities, golf courses/ranges, resorts, casinos, and industrial buildings. These percentages are based on 31 years of cost segregation experience and thousands of studies.
The Financial Benefits
The financial benefits of a cost segregation study increases your cash flow tax benefits achieved from accelerated depreciation.
Increased net present value of tax savings achieved from accelerated depreciation. Independent third-party analysis that will withstand Internal Revenue Service examination.
A client recently purchased 14 restaurants, at a total purchase price of $7,898,200 (without land). Their accountants did not allocate any of the purchase price into shorter depreciable tax lives and treated the entire $7,898,200 purchase price (without land) as 39-year property.
The following graph shows the actual financial benefits derived from a recently completed Cost Segregation study. As you can see, a Cost Segregation study was enormously beneficial to this company.
Obtain and review
a schedule summarizing the general contractor’s construction costs and the owners’ costs, the contractors’ pay requests, copies of change orders and dollar amounts associated with each item and copies of all invoices paid by the owner to subcontractors and vendors other than the general contractor
Analyze and reconcile
project-related cost information to the owners’ general ledger and fixed asset accounting records
the site work, architectural, structural, mechanical, electrical, and construction blueprints along with equipment layout drawings to develop a thorough understanding of the construction project
an on-site visit and inspection of the facility to identify and reconcile our review of the blueprints
our cost engineering/estimating takeoffs from the blueprints
the general contractor’s indirect project costs to each estimated take-off. Next, the owner’s indirect costs are allocated to each estimated take-off
each individual take-off into the proper asset classification according to Rev. Proc. 87-56 for federal and state income tax purposes
a fully documented report
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147 Prince Street
Brooklyn, NY 11201
(718) 855-6110 ext. 161
(718) 852-9609 Fax
Toll Free: 877-405-4321