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Who may benefit from a Cost Segregation Study?
Any person (individual or business entity) who pays income taxes and owns developed real estate purchased, constructed or improved since 1987 may benefit from a cost segregation study.
Can estimates (guesstimates) be used to determine segregated costs?
No. According to the IRS, estimates that have no basis in fact may not be used to segregate costs from the building. An actual cost segregation study is required and must be performed using a qualified architect, construction engineer or construction estimator that can provide a definitive audit trail to prove the segregated costs.
Is there favorable legal precedent to substantiate a cost segregation study?
Yes. The most significant case is Hospital Corporation of America, et al. v. Commissioner of IRS (109 TC 21 [1997]). The court decided that if building property would have qualified for the old Investment Tax Credit, that same property qualifies as tangible personal property depreciable under MACRS over five or seven years.
Does a Cost Segregation Study generate additional depreciation deductions over the building's life?
No. Total depreciation over the life of the building will not change. A cost segregation study changes the timing of the depreciation deductions, allowing for a greater amount of depreciation to be deducted in the first 15 years of the building's life; and, a significant portion of that will be deducted in the first five or seven years. This is what creates the NPV benefit.
Can I benefit if I sell my building in the near future?
Possibly. It is arguable that the reasonable fair market value (FMV) of most of the segregated tangible personal property and land improvements can be deemed equal to the book value (Cost less accumulated depreciation) upon disposition. Therefore, no gain or loss would be recognized on the disposition of these assets while most or all of the selling price would be allocated to building and land. As a result, the depreciation taken on the land improvements and tangible personal property segregated from the cost of the building would be recaptured in the form of additional capital gains taxed at 15 percent instead of at the highest tax bracket at which you would have reduced your taxes from the depreciation deductions. With the most comprehensive cost segregation projection computer program in the industry, we can incorporate a sale scenario into our projection analysis.
Is there benefit available from demolished assets in a purchased building?
Yes. If you purchase a building and place it into service for at least a short while before renovating, you may be eligible to deduct the cost of the demolished assets in the year of demolition as abandoned property. In this scenario, for every $100,000 of demolished property that is segregated and written off in the year of demolition, a federal income tax NPV benefit of up to about $23,500 is obtained; with up to about another $8,500 for NPV of state income taxes deferred. If renovation takes place before moving operations into the building, the value of the demolished assets must be capitalized to the building.
Does the IRS allow a Cost Segregation Study to be performed on buildings that were purchased, constructed or improved prior to this year?
Yes. A cost segregation study can be performed on any building that was purchased, constructed, or improved as far back as 1987. With the advent of Rev. Proc. 2002-19, "Catch-up" depreciation is recognized all in the first tax year affected by the study, no matter how much the change to income resulting. Prior to Rev. Proc. 2002-19, the "catch-up" depreciation was to be recognized on a prorated basis in four equal parts over the first four tax years, beginning with the first year affected by the study, or all in the first year if the "catch-up" depreciation was not greater than $25,000. This procedure requires an automatic application for change of accounting method (form 3115) to be filed in the first year affected by the study.
Is there significant likelihood of IRS audit with cost segregation?
Not according to the IRS. If you engage in a cost segregation study for the year the building was placed in service, there is no additional filing requirement. For buildings placed in service in prior tax years, generally the requirement is an automatic change in accounting method which the IRS has pre-approved per Revenue Procedure 2002-09 (Superseding 99-49, 98-60 and 96-31), with no amended returns required; although amended returns are an option for tax years still open—generally up to three years back. Bear in mind that you are changing your depreciation method from an incorrect method to a correct method, which is what generates the automatic approval. However unlikely the risk of audit, though, there is no guarantee that form 3115 will not be audited, and so we provide a clean audit trail to support our findings.
Can I end up paying more in income taxes when I sell my building if a cost segregation study is not done?
Yes. IRS regulations require that a taxpayer take depreciation on assets based on what is "allowed" or "allowable." If a taxpayer depreciates 5-year property over 39 years, if it is identifiable to the IRS, they could disallow all depreciation taken beginning in year 7 (5-year property is depreciated over the course of six years.). Additionally, upon sale of the building, the IRS could increase the taxpayer's gain by lowering the basis in the building by the amount of depreciation that should have been taken but wasn't during the first six years of the 5-year property. However, this scenario is highly unlikely in that the IRS would have to generate a cost segregation study on your property in order to accomplish this.
What is required in order to conduct a full-blown cost segregation study?
Generally, for a constructed property we need a complete set of architectural blueprints, your contractor's final application for payment (AIA Document), construction change orders, any relevant invoices that capture cost breakouts for qualifying assets, invoices for additional items not included in the general contract, and a copy of the depreciation schedule showing the costs capitalized from this project, if placed in service in a tax year for which the income tax return has already been filed. For purchased property, we need the escrow statement, a complete set of architectural blueprints, any documentation or blueprints with respect to any renovations and demolished assets, a list of any furnishings or equipment included with the purchase, a list of capital improvements that occurred prior to the purchase but after the initial construction, and a list of capital improvements that occurred after the purchase.
How is cost segregation different from component depreciation?
Cost segregation is where the taxpayer is simply identifying and isolating costs for assets that qualify as tangible personal property or land improvements. This was clearly outlined in HCA. This differs from component depreciation in that component depreciation was used for the addition of structural replacements on buildings that were placed in service before 1981 where the new component was permitted to be depreciated on an accelerated basis and for a much shorter life span than that of the building. Those same structural components do not qualify for acceleration or shorter life span today, either.
If I don't have architectural blueprints, is cost segregation still possible?
Yes, however, the architect or construction engineer on the cost segregation job will have to conduct the study completely or partially on-site, which will add costs to the overall project.
Will I still benefit if I am subject to the passive loss rules (PAL), net operating losses (NOL), or the alternative minimum tax (AMT) or because I am a nonprofit entity that doesn't pay income taxes?
As for the latter, you definitely will not benefit. If you don't pay income taxes, additional deductions will not help you. As for the other three, however, if you have income from other passive activities against which to offset passive losses, then the losses generated by the building are currently deductible. Also, if you lease your building to a business that you own and materially participate in, if by leasing the building to your business at the highest possible rental FMV you generate rental income, additional depreciation will benefit you to the extent of that income. If a NOL is generated, you may be able to carry the loss back two or more years to years with income and claim an immediate tax refund. If you are subject to the AMT or if a study causes you to become subject to the AMT, you will still benefit from a cost segregation study, just not by as much, as long as you are not limited by PALs or NOLs. We can incorporate AMT scenarios into our projection. AMT lives are the same as regular tax lives since 1999, only the acceleration is lessened, e.g., 200 percent declining balance becomes 150 percent. Before 1999, the lives were different, e.g., 5-year property was 9-year property for AMT. Even so, it is better to get 9-year treatment at 150 percent declining balance than 39 or 40-year treatment at straight line. Please consult your CPA or tax advisor to assist you in determining how any of these scenarios would impact your taxes.
Would it be worthwhile to wait to the future for a cost segregation study?
Since the benefit from cost segregation is based on the time value of money, the longer you wait, the more NPV benefit you forfeit. Also, by doing one in the year of acquisition or construction, you avoid the additional filing requirement that signals the IRS that you engaged in a cost segregation study; thus reducing the risk of scrutiny.
How is the projected NPV benefit determined in advance?
You or your CPA simply provides us with certain information that we will request, and using historical results of similar property, we will provide you with a complimentary feasibility analysis that will show your projected NPV tax savings with a year-by-year breakdown of the change in cash flows.
Is cost segregation possible for §1031 like-kind exchange-acquired buildings?
Yes. However, we would apply a ratio of adjusted basis to FMV of the property acquired to the entire study. So, if your basis was 75 percent of the FMV of the property studied, all 5, 7, 15, and 39-year property resulting from the study would be reduced by 25 percent. Even though §1245 tangible personal property is segregated from the total for income tax purposes after the exchange, as long as state law provides that all assets obtained in the trade qualify as "realty," there will be no gain recognized on the exchange. This would be the case in most states. For example, even though certain plumbing qualifies as tangible personal property, it is still considered realty with respect to state real estate law. Where you trade a building, the §1245 tangible personal property costs of which have already been segregated, no gain would be recognized on trade if the FMV of the §1245 tangible personal property traded was no greater than the adjusted basis of those assets--which will almost always be the case. Think of it this way: "What would the FMV of used plumbing be?"
Will I benefit if tax rates are reduced or if the income tax code is repealed?
If this happens, you benefit even more! This is because you will recognize significantly greater depreciation now while the higher rates are in effect. In the later years you will recognize less depreciation generating a negative cash flow as a result of front-loading additional depreciation in the early years. If the tax rates are lower in the later years, then this negative impact in those later years is mitigated; if the income tax code is repealed, then this negative impact in those later years is completely eliminated! And if a cost segregation study has not been prepared, you forfeit much depreciation expense for which a tax benefit will never be realized.
Is there a minimum building cost required for a cost segregation study? What assurance is there that the NPV benefit will exceed the cost of this study?
There is no minimum building cost required. We will provide a complimentary feasibility analysis to estimate the NPV of deferred taxes you can expect from a cost segregation study of your building. Since this analysis is free, there is no reason not to examine any building. And very simply put, if we find that our NPV estimate is not significantly greater than our fees, we won't do the job. We also guarantee you in writing that you will be better off having the study done than not having it done.
How much in NPV of deferred taxes can I expect?
Based on historical averages, for every $100,000 invested in total building costs, approximately $5,000 of NPV of deferred taxes can be expected. This amount will vary depending on the type of building, when it was acquired, and your marginal federal and state income tax brackets. Put another way, for every $100,000 of building costs that are classified as tangible personal property and depreciated over five years using MACRS, approximately $20,000 is realized in NPV of deferred federal taxes -- $18,000 for seven-year property and $11,000 for 15-year land improvements.
When can I expect a return on my investment in a cost segregation study?
Immediately!! In most cases, the tax savings in Year 1 will far exceed the entire cost of the study. What's more, the fees are entirely tax deductible!
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