| Home Online Publications Online Issues TTA Home Table of Contents Clinic Index Real Estate | |
Cost-Segregation Studies: Good News for Clients A cost-segregation study is a valuable tax strategy for taxpayers who currently own, are constructing or renovating, or who are acquiring real estate. The reason is simple: tax deductions for depreciation are taken earlier, which translates into a present-value, cashflow benefit.
Depreciation Prior to 1981, taxpayers could depreciate each component of a building separately; for example, the shell might be depreciated over 40 years and the roof over 20. This generally resulted in a composite depreciable life of approximately 20–25 years. The Economic Recovery Tax Act of 1981 eliminated this, requiring all taxpayers to depreciate new or used real estate over 15 years. With such a short composite depreciable life, taxpayers did not care about losing the ability to componentize. This schedule was short-lived, however. The Tax Reform Act of 1986 substantially lengthened the depreciation life of real estate from 19 years, to 31.5 years for nonresidential property, and to 27.5 years for residential property. Today, it is 39 years for nonresidential real estate. As a result, real estate owners are now locked into a mandatory, long depreciation life with no ability to componentize. Although component depreciation was no longer available, the ability to identify personal property embedded in the cost of real estate was still available. Such property could be depreciated over much shorter, modified accelerated cost recovery system (MACRS) lives. Cost-segregation studies make it possible to identify assets installed in a building and to reclassify the allocated costs to Sec. 1245 property, which can be depreciated over shorter lives, ranging from three to 20 years (usually, five, seven or 15). These studies can be performed on just about any property type, including office buildings, hotels, manufacturing facilities, warehouses, restaurants, automobile dealerships, etc.
Segregating Costs HCA: The general authority for segregating costs between building and personal property stems from Hospital Corp. of America (HCA), 109 TC 21 (1997). In HCA, the Tax Court ruled that if property would have qualified as tangible personal property for investment tax credit purposes, it is properly classified as Sec. 1245 property. Guidance for this conclusion was found in an earlier Tax Court case dealing with the investment credit; see Whiteco Industries, Inc., 65 TC 664, 672–673 (1975). The court in Whiteco laid down six criteria to help identify whether property was inherently permanent (and, thus, not tangible personal property):
The HCA decision considered the costs incurred to construct a facility and segregated them between structural and nonstructural components. The court held that HCA could depreciate, over five years, a percentage of the electrical systems, measured by electrical load allocable to hospital equipment, as opposed to general building operation or maintenance. Qualifying hospital equipment for HCA included equipment in operating rooms and kitchens, computer-room air conditioners, etc. Other non-equipment-related assets that qualified for five-year depreciation consisted of carpeting attached to the floor with latex adhesive (easily removed), vinyl floor and wall coverings and accordion-style room partitions. Tax savings: The exhibit below at right shows that the difference between 39-year and five-year deprecation results in a significant present-value tax savings, which translates into enhanced cashflow. Thus, in providing clients with a cost-segregation study, tax advisers can help them to reduce their taxable income with accelerated depreciation, which results in increased after-tax cashflows.
CCA: In following the HCA decision, the IRS issued Chief Counsel Advice (CCA) 199921045, providing guidance for examiners in response to the Tax Court’s decision. The CCA clarifies that taxpayers must have contemporaneous documentation to substantiate any reclassification from Sec. 1250 to Sec. 1245. The required documentation is a “cost segregation study” to support the claim that part of an investment in a building is eligible for more rapid depreciation. Accelerated depreciation under MACRS will not be allowed without a “logical and objective measure” clearly illustrating the portion of building equipment constituting Sec. 1245 property.
Requirements A proper cost-segregation study consists of the following:
Strategies The following is a summary of some additional considerations and benefits available to clients. Look-back studies: For assets purchased, renovated or constructed in earlier years, under Rev. Proc. 2004-11, the IRS allows the catch-up depreciation deduction to be claimed in the year the study is completed and Form 3115, Application for Change in Accounting Method, is attached to a timely filed return (including extensions). The real advantage is that there is no such thing as a closed year for this benefit. Bonus depreciation: Look-back studies can identify personal property that would have qualified for bonus depreciation when first placed in service, so it can be claimed by the taxpayer, as long as the taxpayer had not elected out of bonus depreciation in the earlier period. Energy-efficient commercial buildings deduction: This deduction may provide additional benefits. For costs allocated to building, a deduction will be allowed under Sec. 179D for the cost of major energy-saving improvements. This was included in the Energy Policy Act of 2005. The deduction is aimed at giving owners an incentive to design and install property that will reduce total energy and power costs. The calculation is complex and strict standards apply to meet the qualifications. This deduction should be considered when performing the study, as the energy deduction will reduce the property’s basis. Demolition: Under Sec. 280B, demolition costs cannot be expensed, but only capitalized as land cost. Rev. Proc. 95-27 provides a safe harbor to avoid the harsh treatment of Sec. 280B. Essentially, if 75% or more of the existing external walls of the building are retained in place as internal or external walls, and if 75% or more of the building’s existing internal structural framework is retained in place, then the demolition costs can be recovered through depreciation deductions as part of the allocated cost to the building. Personal property taxes: For most states, reclassifying building costs to personal property should not affect personal property taxes. Local law defines real property or personal property for property tax purposes. Generally, the reclassified costs resulting from a cost-segregation study will continue to be taxed as real property for property tax purposes. Thus, it is important to keep track of newly found personal property and not report it on personal property tax forms, to avoid double property taxes. Interaction with like-kind exchanges: Cost-segregation studies generally re-classify Sec. 1250 property as Sec. 1245 property for depreciation purposes. Sec. 1245 property can trigger significant depreciation recapture rules. To the extent the property is disposed of in a like-kind exchange and personal property of equal value is not received, the gain will be recognized at ordinary income tax rates.
Conclusion Tax deferral strategies minimize taxes. Cost-segregation studies generally result in 20%–30% of a property’s tax basis being reclassified to five- or seven-year property and, thus, represent a very effective tax-deferral strategy. The use of cost-segregation studies will likely increase, and the IRS demands the highest level of professional expertise in the areas of engineering and tax accounting to perform the studies. A cost-segregation study remains a vital tool for taxpayers. From Karen J. Koch, CPA, Louisville, KY |
