What is Cost Segregation?
Cost Segregation is a strategic tax savings tool that allows companies and individuals, who have constructed, purchased, expanded, or remodeled any kind of real estate to increase cash flow by accelerating depreciation deductions and deferring federal and state income taxes.
In general, it is easy to identify furniture, fixtures, and equipment (FF&E) that are depreciated over 5 or 7 years for tax purposes. However, a Cost Segregation Study goes far beyond that by dissecting construction costs that are usually depreciated over 27 ½ or 39 years. The primary goal of a Cost Segregation Study is to identify all construction-related costs that can be depreciated over 5, 7 and 15 years. For example, 30% to 90% of the total electrical costs in most buildings can qualify as personal property (depreciated over 5 or 7 years). Reducing tax lives results in accelerated depreciation deductions, a reduced tax liability, and increased cash flow.
What are the Benefits of a Study?
· Generates immediate increase in cash flow through accelerated depreciation deductions.
· Reduces income taxes and can also reduce real estate property taxes.
· Provides an easy opportunity to claim 'catch up' depreciation on previously misclassified assets.
· Provides an independent third-party analysis that will withstand IRS review.
When should a Study be conducted?
The ideal time for a Cost Segregation Study can vary depending on a client's tax situation. A Cost Segregation consists of a team of engineers and tax experts work together with clients and their accountants to recommend the best tax planning solution to fit their needs.
· Post-purchase, Remodel, or Construction: "Look-back" Studies: A Study can be completed anytime after the purchase, remodel, or construction of a property. In fact, current Internal Revenue Service procedures make it easy to go back and claim missed depreciation on assets acquired as far back as 1987 without amending prior tax returns.
· Year Placed in Service: The optimum time for a Study for new owners, is during the year a building is constructed, purchased, or remodeled. This allows an owner to immediately optimize tax savings and accurately classify assets before the building even begins to depreciate.
· Pre-construction: For investors who are in the planning phases of construction or remodeling, the best time to consider a Cost Segregation Study is before the infrastructure of the building is set. It is recommended that an investor seeks Pre-Construction Consulting which allows the project's accountant and construction contractor to accurately track items that qualify for accelerated depreciation and ultimately saves time and money.
What Kind of Real Estate Qualifies?
Any structure used for business or as rental property, is eligible for the benefits of Cost Segregation. The graph below represents the percentages of project-related construction costs that could be reclassified from either 27.5 or 39-year real property to 5, 7, or 15-year property.
Other projects benefiting from Cost Segregation are shopping malls, airports, sports facilities, driving ranges, resorts, health care facilities, industrial buildings, auto service centers and more.
Any leasehold improvements can also qualify for a Cost Segregation Study. These interior build- outs generally produce a proportionally higher ratio of qualifying property. Therefore a Cost Segregation Study that analyzes the costs of leasehold improvements can be even more beneficial.
Who can conduct a study?
The following qualifications are needed to ensure an investor obtains the optimum tax savings allowable by law:
· Engineering, construction, and tax expertise: to accurately evaluate, identify and classify assets to appropriate categories.
· Knowledge of changing tax laws: to ensure taxpayers optimize savings within the proper application of current laws.
· Knowledge of prior court cases and rulings pertaining to individual assets: to determine what is personal property. According to the IRS's Chief Counsel Guidance in 1999, the IRS recognizes that there is "No Bright Line Test" for identifying personal property. As rulings in various court cases have proven, different circumstances for the exact same type of asset can change how the asset is depreciated for tax purposes. Therefore, a specialist needs to evaluate the construction method, use, and application of laws pertaining to each asset.
· Compliance with the IRS Audit Techniques Guide: to ensure an accurate study that withstands IRS scrutiny in the event of an audit. The IRS Audit Techniques Guide, issued in 2004, outlines the criteria of a quality Cost Segregation Study and provides direction to IRS field agents when reviewing a report that does not employ the methods suggested.
· Proactive identification of other opportunities: to recognize additional areas of tax savings. An independent third party who specializes in Cost Segregation Studies and other Real Estate Tax services can determine if an investor can benefit from other studies such as: Fixed Asset Studies, Abandonment Studies, and more.
What is involved in a Study?
A quality Cost Segregation Study evaluates all information including available records, inspections, and interviews, and presents the findings in a clear, well documented format. Our process for conducting a detailed Study includes:
· A review of all cost detail for the property including but not limited to: the general contractor's application for payment, construction invoices, change orders, depreciation schedules, and appraisals.
· An inspection of the facility to fully understand its use and condition, as well as to gather information that further supports the classification of capitalized costs into their appropriate class lives.
· Photographs are taken of qualifying construction components and included in our report.
· A review of all blueprints (if available) and the performance of quantity take-offs and cost estimates for personal property not segregated in other cost information.
· A reconciliation of all construction costs and estimates of the actual amounts incurred by tax life. This step includes adjusting estimates to account for location, time, and physical condition. We also perform an allocation of soft costs to any direct cost in each category to maximize your total benefits.
· Preparation of a report: Our report complies with the IRS standards stipulated in the Audit Techniques Guide for Cost Segregation Studies.
The above information was provided by Gregory Kniss, CPA of KBKG, Inc.