Cost segregation studies can help real estate investors maximize after-tax cash flows.
AS THE REAL ESTATE market continues to improve, investors are becoming more focused on maximizing their return on investment for commercial real estate projects. One of the best ways to maximize after-tax cash flow is by accelerating depreciation deductions through the use of cost segregation studies.
Commercial rental property typically is depreciated over 39 years, while residential rental property — including multifamily housing projects — is depreciated over 27.5 years. Certain building components, however, qualify for shorter depreciation recovery periods of five, seven and 15 years. Cost segregation studies are used to reallocate building costs (from Section 1250 property, using straight-line depreciation) to tangible personal property (Section 1245 property, using accelerated depreciation methods).
Items that may qualify for accelerated depreciation include certain site work; drainage systems; landscaping; parking lots; parking and loading dock equipment; carpeting; special purpose electrical as well as heating, ventilation and air conditioning systems; awnings and canopies; sidewalk lighting; and decorative millwork. Specialty items that may qualify include window coverings; furniture; signs; security systems; bollards and guardrails; certain cabinets and counters; specialty doors; specialty lighting; kitchen equipment; refrigeration systems; and drive-thru equipment. Numerous other building components may also qualify.
Cost segregation studies provide the analysis and identification of specific building components necessary to allocate costs into the proper categories for depreciation purposes. According to the Internal Revenue Service’s “Cost Segregation Audit Techniques Guide” (ATG), there is no standard for cost segregation studies. However, the ATG defines a quality cost segregation study as having the following three attributes:
Classifies assets into property classes (e.g., land, land improvements, building, equipment, furniture and fixtures).
Explains the rationale (including legal citations) for classifying assets as either Section 1245 or Section 1250 property.
Substantiates the cost basis of each asset and reconciles total allocated costs with total actual costs.
The benefits of a cost segregation study are illustrated in the table below. In this example, a medical office building costs $5 million and has a 39-year depreciable life. The results of a cost segregation study determine that $500,000 of those costs are for property that has a five-year depreciable life (“five-year property”), $500,000 is seven-year property and $500,000 is 15-year property. If we assume that the effective federal and state income tax rate is 41 percent and the discount rate is 8 percent, the resulting accelerated cash flows for years one through five total $348,343.
While cost segregation studies work well for new construction, they can also provide significant tax and cash flow benefits for existing structures. Taxpayers may benefit from “catch-up” depreciation deductions on existing properties by filing IRS Form 3115, Application for Change in Accounting Method, under the automatic consent provisions of IRS Revenue Procedure 2014-17. The catch-up depreciation is the difference between the cumulative amount of depreciation taken under the originally reported depreciable lives and the amount that could have been taken using the depreciable lives reported by the cost segregation study.
A Changing Landscape
Cost segregation studies have been on the rise since the 1997 tax court case of Hospital Corporation of America Inc. affirmed their use. However, recent court cases and IRS rulings have modified the landscape regarding cost segregation studies.
In a 2013 case, the tax court disallowed the use of a cost segregation study in which Peco Foods had acquired assets in an applicable asset acquisition under the Internal Revenue Code’s Section 1060. The court ruled that since Peco had agreed to an asset allocation under the terms of the purchase agreement, it was precluded from subsequently reclassifying those assets. While the tax court disallowed the reallocation of the assets, it did not question the validity of the cost segregation study. The underlying issue was the language of the purchase agreement, which stated that the asset allocation was to be used for all purposes, including financial and tax reporting. Investors therefore should make sure that purchase agreements include purchase price allocations that support post-acquisition cost segregation.
Also in 2013, the IRS issued final regulations on the deduction and capitalization of expenditures related to tangible personal property. The “repair regulations” address the proper tax reporting treatment for current deductible repairs and capital expenses. The IRS addressed “partial dispositions” in Revenue Procedure 2014-54. Taxpayers may deduct, rather than capitalize, replaced components by making an annual “partial disposition” election.
Because of the complexity of the final regulations, as well as the potentially significant impact to taxpayers — real estate property owners, in particular — the IRS issued Revenue Procedure 2015-20 on February 13, 2015. This new IRS guidance provides simplified procedures for certain small businesses, as well as clarification regarding the application of its provisions. (For additional information, refer to the IRS’s “frequently asked questions” regarding tangible property regulations.)
Tax Planning Opportunities
Careful analysis of the cost allocations of real estate projects, as well as certain improvements, can provide significant after-tax cash flows for real estate investors. Taxpayers should work with their real estate attorneys and CPA/cost segregation specialists to maximize their real estate investment returns by properly analyzing their cost allocations.