Cost Segregation: A Genuine Tax Savings Strategy

In any economy, real estate owners and investors are attentive to the smallest swings in their internal rate of return. In an economic downturn, savvy owners and investors seek out every opportunity to enhance the bottom-line. Formal cost-segregation studies may accomplish this, as they can produce depreciation deductions of significant benefit.

Although cost-segregation studies had been a key tool in a property valuation arsenal for more than two decades, Congress specifically prohibited component depreciation under the Tax Reform Act of 1986. Faced with this restriction, taxpayers became reluctant to take any action that resembled component depreciation. However, in Hospital Corporation of America (HCA), 109 TC 21 (1997), HCA prevailed in its allocation of personal-property classifications, creating fresh interest in the tax-planning possibilities of this approach. In the ensuing five years, knowledgeable tax professionals have been fine-tuning cost-segregation studies to save significant tax dollars for clients that own or lease real estate.

What Is a Cost-segregation Study?

Practitioners have been doing depreciation analyses for years, identifying specific items like carpeting, appliances or landscaping, and accelerating their depreciation under modified accelerated cost recovery system standards. However, such a depreciation analysis is not cost segregation. A cost-segregation study acceptable under IRS standards is an extensive review that analyzes a property's construction to isolate its structural elements. Taxpayers can depreciate components that are not part of a building structure over shorter time periods. Moreover, a cost-segregation study also considers a property's "soft costs" (such as architect and engineering fees) to determine their allocation.

Example: Taxpayer N owns a multi-family rental property that cost $18 million to build. Under the standard method of depreciation, this total would have been depreciated over 27.5 years. Under an accelerated method, 15% of this amount is attributable to personal property (depreciable over five years) and 5% to land improvements (depreciable over 15 years). By carefully examining construction documents and plans, however, the amount attributable to personal property is determined to be 20% of the total cost, and the land improvements an additional 13%. As a result, the taxpayer realizes $940,000 cashflow from tax savings from the additional depreciation deductions in the first five years.

In the example, if the taxpayer had used the accelerated method, he would have saved only $705,000. Thus, the taxpayer has $235,000 of additional cashflow from using a cost-segregation study.

How Is a Cost-segregation Study Conducted?

Cost-segregation studies that result in significant tax savings demand far more analysis than simply classifying line items from the contractor's schedule of values. An analysis of mechanical and electrical plans and blueprints, which segment the structural electrical and mechanical components from those linked to personal property, is critical. The Service generally anticipates this level of detail in a bona fide cost-segregation study.

Additionally, taxpayers should include a site visit for projects under construction, ideally after the contractor completes the rough carpentry, plumbing and electrical work, but prior to "finish" of work. This allows taxpayers to question the project manager and to observe construction, to segment moveable items from fixed ones. For example, a site visit might permit the identification of a building trash compactor as personal property, if the unit was distinct from the building's structure (i.e., bolted—not welded—onto a special concrete slab, which would allow for periodic replacement). This sizeable piece of personal property might be overlooked if taxpayers do not conduct an on-site inspection.

Studies of existing facilities that a taxpayer intends to acquire are even more essential, as plans and blueprints for such properties are often unavailable. In such circumstances, an analyst must use the site visit for observations and calculations, such as determining the square footage of the parking lots to calculate the number of cubic yards of concrete required for construction. Industry standards can then provide the historic cost of this land improvement.

A thorough and complete cost-segregation study should also cite case law or other IRS authority to support positions taken for the personal-property and land-improvement classifications.

Cost-segregation studies are applicable to properties that are newly built, rehabilitated or acquired—from retail, office and industrial buildings to hotels, shopping centers and healthcare facilities. Specialized cost-segregation studies for manufacturing and hotel projects can result in a taxpayer classifying up to 40% of total construction costs as nonstructural. Significant savings are also possible on moderate-sized projects.

How Much Does a Cost-segregation Study Cost?

The fee for a cost-segregation study depends on the scope and scale of the analysis and the condition of the available documents. Potential tax savings are enormous, with studies typically paying for themselves many times over.

From Robert Langley, CPA, and Marianne Heard, CPA, MST, Boston, MA