Cost Segregation Studies

The benefit of a cost segregation study (CSS) is well known to many tax advisers (see Langely and Heard, Tax Clinic, "Cost Segregation: A Genuine Tax Savings Strategy, TTA, April 2002, p. 215). Absent a CSS, newly constructed or purchased property often yields only modest depreciation deductions. By breaking out shorter modified accelerated cost recovery system (MACRS) depreciation lives for personal property and 15-year land improvements from 31¹/2- or 39-year real-property depreciation, a CSS could greatly accelerate a building's tax depreciation.

The new accounting-method-change rules set forth in Rev. Procs. 2002-9 and 2002-19 provide further reason for a CSS: they allow taxpayers who did not previously use a CSS to conduct one now for a building placed in service in an earlier year. Using a Sec. 481(a) adjustment, a taxpayer can take in one year all previously forgone depreciation that would have been available in prior years for a shorter-life property. The procedures allow taxpayers to request an accounting-method change up until a return's extended due date. This allows taxpayers to plan and secure additional deductions retroactively after the close of the tax year.

Considerations

Even though a CSS is often an effective tax-planning tool, taxpayers should first consider whether their circumstances make a CSS advisable. First, for less expensive building projects, a cost/benefit analysis should be calculated, comparing a CSS's cost against the net present value (NPV) of the projected tax savings. Typically, a proposal to perform a CSS will include an estimated NVP as an attachment (see Exhibit 1). However, this calculation normally assumes the project will be held for a real property's full life (i.e., 31¹/2 or 39 years). If a taxpayer is planning a taxable sale of the property within a short time, justification becomes difficult, because the benefits are in timing differences that will ultimately reverse (see Exhibit 2).

Second, by carving out personal property from the building, a portion of the gain on any future sale could be taxed at ordinary rates as Sec. 1245 gain on personal property depreciation recapture. Absent a recharacterization of the property under a CSS, the real-property Sec. 1250 depreciation recapture rate would be only 25% for noncorporate taxpayers.

Many practitioners attempt to mitigate this result by arguing that the personal property's fair market value (FMV) at the sale date is equal to or less than the depreciated tax basis. This argument might be difficult to sustain on an IRS examination if the personal property is fully depreciated or the new buyer is conducting a CSS that quantifies a significant amount of the personal property's FMV at the sale date. The rate differential on a reversal of the depreciation could negate the savings from the timing difference on the MACRS depreciation.

Third, the presence of personal property may make entering into a tax-deferred Sec. 1031 like-kind exchange more difficult. If a taxpayer were to trade into real property with little or no personal property (e.g., unimproved land), the FMV of the personal property relinquished would be treated as boot (the real property received for the portion of personal property relinquished would not be like-kind and, thus, subject to tax).

Even if improved property is exchanged for another improved property, taxable gain could still result. Because the property consists of both real and personal property, a taxpayer is required under Sec. 1031 to separate the assets into exchange groups. Each exchange group comprises properties in either the same "general asset class" or "product class" as defined under the regulations. The difference between the FMV and the adjusted bases of the properties transferred within each exchange group determines that group's realized gain or loss. If the FMV of the properties received within the exchange group (less any excess liabilities assumed by the taxpayer that are allocated to that exchange group) exceeds the FMV of the properties transferred within the exchange group, gain will be recognized, to the extent realized. Losses, however, will not recognized.

Fourth, if a taxpayer's trade or business activity is passive and already generating a suspended loss, or the taxpayer has net operating losses, the value of the accelerated tax deductions is greatly diminished.

Finally, if a taxpayer is exposed to alternative minimum tax (AMT), the benefit of a CSS decreases, for two reasons. First, the difference between AMT lives and methods for personal and real property is not as significant as that for regular tax purposes. For example, seven-year MACRS property (which approximates the double-declining-balance method) becomes 10-year, 150%-declining-balance property for AMT purposes, while a nonresidential real property's MACRS life increases only from 39-year to 40-year straight-line depreciation for regular and AMT purposes, respectively. The NPV of the tax benefits is decreased further, because the AMT rate would be much lower than Exhibit 1's as-sumed 40% regular rate used to calculate the tax benefit (see Exhibit 3).

While a CSS on larger projects will pay for itself many times over, tax advisers should consider the circumstances discussed above in considering a CSS for less expensive building projects.

From Curt J. Welker, CPA, PKF, San Diego, CA