New regulations further expand the utility of engineering-based tax strategies.
MANY COMMERCIAL REAL estate professionals are familiar with the basics of cost segregation — the practice of classifying assets and their costs for federal tax purposes — but few have taken full advantage of the possible opportunities it may yield. In recent years, new permanent tangible property regulations (TPRs) have expanded the utility of cost segregation and related services, resulting in more ways to capture deductions than ever before.
To illustrate the diverse applications of engineering-based cost segregation tax strategies, which require an understanding of both construction and tax law, and which enable commercial real estate owners to accelerate the depreciation periods for various building components, let’s walk through a few scenarios using the same sample property. This sample property is a four-story, 100,000-square-foot multitenant office building purchased and placed in service in 2010. A primary tenant occupies 40 percent of the building, which the owner acquired for $12 million. After subtracting a $2 million land allocation, the owner’s depreciable basis is $10 million.
Under the first scenario (see the table at left), the owner had an engineering-based cost segregation study (CSS) performed upon acquisition in 2010. Under the second, the owner did not have CSS performed until 2016.
Cost segregation is clearly a powerful tax and cash flow savings tool, whether performed immediately after the property is placed in service or several years later. The economics of the look-back study are indeed superior, in comparison to the results of the scenario one study. Under scenario one, however, the taxpayer would have had access to the additional cash flow starting in 2010, while a taxpayer electing to perform a look-back study would not have had this advantage. This is the essence of cost segregation. Both approaches are beneficial. The decision ultimately depends upon the owner’s tax position and selected tax strategy.
Consider a third scenario, in which the owner acquired the property in 2010 and had CSS performed immediately after the acquisition. Now, in 2016, the primary tenant has vacated its 40,000 square feet, which will be gutted and renovated. The landlord is paying $100 per square foot for tenant improvements (TI), a total of $4 million. Other improvements to be implemented simultaneously include the following:
- Seal coating the parking lot, at a cost of $200,000.
- Refreshing the lobby ($100,000).
- Replacing two of 10 interior decorative metal wall panels at the property for a cost of $1,800 each ($3,600).
A series of crucial regulations that clarify the expense versus capitalization decision process, the TPRs also provide for partial asset disposition elections (PAD) and establish three diverse “safe harbors” under which property owners can expense assets. Decisions of this nature require more detailed data than that generated by the average CSS. However, unit of property (UoP) studies provide the aggregated cumulative data required to support these decisions. Thus they are a critical service to request in a cost segregation analysis.
If an updated cost segregation analysis, including UoP, were to be performed on the renovated space, the strategies presented at left could be applied.
The overwhelming amount of favorable regulations referenced above demonstrates that there has never been a better time to explore the world of engineering-driven tax strategies. A team approach that includes tax accountants can tailor a unique, individualized slate of services to optimize tax efficiencies for any commercial property ownership scenario.