The Tax Reform Act of 1986 devastated the commercial real estate market by effectively doubling the depreciation lives for many types of buildings. This effectively reduced allowable annual depreciation expense and increased the real estate owner's income tax liability. Since the TRA of 1986 there have been a number of court cases that ruled in favor of cost segregation, the most notable being the 1997 Hospital Corporation of America case (HCA v. Commissioner) in which the court ruled that the definitions of personal property, as previously developed by the courts during the investment tax credit era, are still good law. The HCA case served as a landmark decision for cost segregation, providing the legal support to use cost segregation studies to compute depreciation.
What is a Cost Segregation Study?
Cost segregation is the process of identifying personal property or nonstructural assets (depreciated over 5, 7 or 15 years) that are grouped with real property assets (depreciated over 27-1/2 or 39 years) and separating out these personal property assets for tax reporting purposes. It's easy to identify furniture, fixtures and equipment that are depreciated over 5 or 7 years for tax purposes. However, a cost segregation study digs deeper by dissecting construction costs that are usually depreciated over 27-1/2 or 39 years. For example, 30% to 90% of the total electrical costs in most buildings may qualify as personal property. Once these nonstructural assets are identified, they can be depreciated over 5, 7, or 15 years rather than over 27-1/2 or 39 years.
What are the benefits?
When depreciation schedules are shortened, depreciation expense is accelerated, which results in a reduced tax liability and increased cash flow. By decreasing current income, taxes are deferred to a later tax period. Simply put, a tax deduction today is worth more than a tax deduction next year, and worth a lot more than a tax deduction 30 years from today.
Although savings vary based on the size and type of project, owners routinely receive present value cash flow savings at least 10 or more times their investment (stated differently, the cost of the studies generally range from 10% to 20% of the net present value of the estimated tax savings).
In addition, taxpayers can capture immediate retroactive savings on property added since 1987. Previously, this catch-up period was only allowed over a four year period. The opportunity to recapture unrecognized depreciation in one year presents an opportunity to perform a retroactive cost segregation study on an older property to increase cash flow in the current year.
Real property eligible for cost segregation include buildings that have been purchased, constructed, or expanded or remodeled since 1987. Examples include apartment complexes, hotels/motels, office buildings, medical centers, and manufacturing plants (with the greatest benefit seen in the latter). Although a study is typically cost-effective for buildings purchased or remodeled at a cost greater than $500,000, I recommend you speak with a firm with expertise in engineering, construction, and tax law to determine if a study would prove beneficial to you.
When should the study be performed?
The ideal time for a cost segregation study can vary depending on an owner's tax situation. Generally, the ideal time for beginning the study is when plans are being drafted to purchase, construct, expand, or remodel a building. The firm preparing the report will want to tour the building, review site plans and blueprints and compile a comprehensive file of research supporting the study.
Please contact one of our Commercial Lending Officers if you have any questions regarding cost segregation studies.