Cost Segregation Studies

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How to Accelerate Your Depreciation Deductions
by David Grant, CPA/CVA

Real estate owners and investors have rued the day the Internal Revenue Code of 1986 became law. Along with the dagger of passive loss rules, came the lengthening of depreciation lives on both commercial and residential real estate. A little known tax saving device called a Cost Segregation Study can help accelerate tax depreciation, mitigating, to some degree, the lengthened depreciation lives.

How Cost Segregation Works
While personal property is usually depreciated over a seven-year life, real property is typically depreciated over 39 years (commercial property) or 27.5 years (residential property). A CSS can identify properties that qualify as shorter-lived assets and shift them from a 39-year life to 15-year, seven-year and possibly even a five-year life.

In certain cases construction-related soft costs may also be allocable to the shorter-lived assets. The result is a faster write-off of costs previously included as real property.

What Properties Qualify for CSS?
Cost Segregation Studies can be performed on purchased facilities, newly constructed facilities and even major tenant leasehold renovations. Studies can be performed for real estate holdings placed in service as far back as 1987, even if the year is "closed" for tax purposes. A current IRS revenue procedure (see IRS Revenue Procedure 99-49 described below) permits companies that have claimed less than the allowable depreciation in prior years to claim the omitted depreciation over a four-year period on a going forward basis. In addition, the segregated components continue to be depreciated over shorter lives going forward.

Savings derived from these Studies flow directly to owners and investors by reducing current taxable income with no change in current cash flow.

Do I Qualify?
Answer yes to these four questions and you qualify.
Qualifying questions:

1. Can you benefit from accelerating tax depreciation on your real estate holdings?
2. Have you purchased, constructed or expanded your real estate holdings any time after 1986?
3. Is the cost of your property or expansion at least one million dollars?
4. Do you expect to retain your real estate holding for at least the next three or four years?

How Much Can I Save?
CSS's have generated millions of dollars in current federal and state income tax savings to owners of real estate. Our experience in performing cost segregation studies indicates that the savings can be five percent or more of the asset cost. On a $5 million property, for example, a five percent benefit would generate $250,000 in tax-savings. Savings of anywhere from $50,000 to $1 million, or more, are routine.

What Factors Determine
How Much I Can Save?
The savings derived from a CSS will vary based on three factors:

• The type of property (i.e. office, industrial, residential, etc.)
• The cost of the property; and
• The year it was placed in service.

While certain properties get a bigger bang for the buck than others, we have found that almost every type of real estate can benefit to some degree. By segregating the shorter-lived personal property from long-lived property, we can greatly accelerate depreciation deductions. The greater the depreciation deductions today, the greater the present tax savings. The greater the present tax savings the greater the present cash flow, which in turn can be used to underwrite current or future acquisitions.

What Property Type
Benefits the Most?
Certain types of property yield higher tax saving benefits than others. The properties that generate the greatest benefits include specialty use buildings, such as medical facilities, manufacturing facilities and high end office buildings, to name a few. Warehouses and industrial properties tend to yield lower benefits, while residential garden apartments fall somewhere in the middle. Even large tenant fit-outs can qualify for substantial benefits as well.

What is a Cost
Segregation Study?
A CSS is the process of reviewing and identifying the costs a company incurs to acquire, construct or expand its real estate holdings. It identifies the specific types of assets being placed in service and often leads to a cost allocation that assigns part of the cost to 15-year real property and seven- or five-year personal property. Almost anyone can identify and properly depreciate items such as office furniture and equipment over seven years for federal tax purposes. However, a high percentage of construction related costs, sometimes as high as 40 percent, are too commonly lumped into the building component of the property and depreciated on a straight-line basis over 39 years.

An analysis of costs can be conducted from either the detailed construction records — in the case where such records are available — or by using qualified appraisers, architects or engineers to perform the cost allocation analysis. In both instances, a tax expert is also needed to identify the specific types of property that will qualify as shorter-lived assets.

Is There Tax Exposure?
In our experience, a properly performed CSS does not create additional exposure to a tax audit. Depreciation is far from the highest priority with the IRS. The benefits of a CSS come from the acceleration of tax deductions, not taking a tax deduction for something the taxpayer is not already entitled to. If the property is held for its entire depreciable life, the IRS will get all that it is entitled to. The benefit from a CSS comes from the time value of money generated by current tax savings that may eventually be paid back, albeit, 20 or so years later.

How Can CSS be an
Estate Planning Tool?
When property changes hands through an estate, the tax basis of the property will generally step-up (usually increase) to fair market value. This stepped-up basis starts a whole new depreciable life for the property. The property could have been 40 years old and fully depreciated prior to the death, however, in the hands of the beneficiary the property must be depreciated based on its stepped-up value. This is an ideal time to consider a cost segregation study.

What Did the HCA
Case Do For CSS?
In the Hospital Corporation of America and Subsidiaries (HCA) v. Commissioner, 109 TC (1997), the taxpayers had a major victory. The court concluded that property qualifying as tangible personal property under former investment tax credit (ITC) rules would also qualify in the same manner for purposes of tax depreciation. Thus, practitioners can look to the guidance under the former ITC rules when determining whether property is depreciated as real property (i.e., 39-year recovery period) or personal property (i.e., generally a five- or seven-year recovery period).

The court also concluded that items such as kitchen hoods and exhaust systems and wiring for telephone and communications systems, to name a few, were tangible personal property rather than structural components of the building because the items were related to furnishing medical services rather than providing building services. We would expect that similar logic should apply to other industries and activities, particularly where a part of a building's features are for the specific use of the company's business operations.

What Does IRS Revenue
Procedure 99-49 Do For CSS?
This Revenue Procedure allows taxpayers to retroactively change their method of accounting for depreciation without having to file an amended tax return. The missed depreciation (catch up amount) is recovered over a four-year period starting in the year of change. Rev. Proc. 99-49 describes the requirements and procedures for a taxpayer to obtain an automatic consent to change methods of accounting.

FOR MORE INFORMATION ON THIS TOPIC

NAIOP Government Affairs Industry Issues Check out NAIOP's resources on commercial real estate tax issues. Internal Revenue Service Find more information on the Internal Revenue Code.

Examples of Cost Segregation
These case studies further illustrate the tax savings benefits of cost segregation:

• A Company constructed an $11 million office building in 1988. During the first 10 years of operations, depreciation expense was originally calculated as $3.3 million. As a result of a cost segregation study, the company was able to increase its depreciation expense by over $1.6 million during the next four years. This resulted in discounted present-value tax savings and additional cash flow of more than $340,000 to the company.

• An $8.5 million nursing home was constructed in 1987. As originally calculated, depreciation expense during the first 11 years of operations was approximately $2.6 million. After a cost segregation study was performed, the company was able to deduct an additional $1.6 million of depreciation spread over the next four years. This resulted in tax savings and additional cash flow of over $500,000 during the four-year period.

• An office building complex costing $48 million was acquired in 1995. The owner made tenant improvements of $2 million to the facility over the ensuing two years. As originally calculated, the depreciation expense from 1998 to 2001 was $5.05 million. A cost segregation study that identified improvements such as millwork, wall coverings, kitchen plumbing, telecommunications wiring and supplemental air conditioning, to name a few, increased depreciation expense during that four-year period by $2.3 million. This led to tax savings and additional cash flow of over $700,000 to the owner.

The opportunity for individuals and companies that own or have investments in real estate to realize significant financial benefits through cost segregation is substantial, as are the savings. With tax laws and interpretations continually changing, the time to act is now.

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David Grant, CPA, CVA, is a member in the Real Estate Industry Group at Mintz Rosenfeld & Company LLC, Fairfield, NJ. He previously worked as a CFO at a commercial real estate firm in New York City.

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