Maximize Cash Flow with Cost Segregation Studies

Once only available to Fortune 500 companies via the Big Four accounting firms, the cost segregation study (CSS) is becoming an effective means for much smaller firms to reduce their current taxes—not only on newly constructed properties, but on existing properties, as well.



A CSS involves the integration of cost engineering and accounting to ultimately provide a defensible document to support accelerated depreciation of real estate. A CSS identifies assets that can be reclassified as 15, 7, or 5 years from 39-year property (or 27.5 for residential).



A CSS can be done on new construction—where detailed drawings and cost data is readily available—or on existing properties going back to as far as 1987. Until recently, this practice has been reserved for very large corporations but there is often significant benefit to owners who have buildings with values as low as $700,000.



To determine if your real estate is eligible for CSS, consider these qualifiers:



1. Do you use accelerated depreciation as a tax strategy?

2. Is the value of your building(s) greater than $700,000, excluding land?

3. Was the property placed in service after 1987 (preferably after 1993)?

4. Have you contracted any major renovations or new construction since September 11, 2001 (to determine if bonus depreciation is available)?

5. Are you looking for ways to save on taxes?



If you answered ‘yes’ to these questions, then chances are good that you would benefit from a CSS.



Historical Perspective



Until 1986, the use of cost segregation was fueled largely by the Investment Tax Credit (ITC). The Tax Reform Act of 1986, however, disallowed ITC and the practice was discontinued. In 1996 the IRS issued Revenue Procedure 96-31 which for the first time allowed a taxpayer to correct mistakes made in the depreciation of assets. Based on this revenue procedure, it was possible to use a cost segregation study to correct the depreciation of real property by accurately categorizing the assets into their proper lives.



Additionally, the Job Creation and Workers Assistance Act of 2002 provided significant benefits with respect to new construction. Essentially, certain assets contracted for after September 11, 2001, and placed in service before January 1, 2005, would be subject to 30 percent bonus depreciation. Bonus depreciation generally applies to qualified assets with depreciable lives of 20 years or less but certain conditions permit the acceleration of “qualified leasehold improvements” regardless of depreciable lives. The Jobs Growth Reconciliation Act of 2003 increased the bonus depreciation to 50 percent on qualified assets contracted for after May 6, 2003, and placed in service prior to January 1, 2005.



A CSS can be performed on a newly acquired property and it can also be performed on a property that has been placed in service many years ago. Taxpayers have the benefit (following the completion of a CSS) of claiming accelerated depreciated on a retroactive basis by filing IRS Form 3115 (Change in Accounting Method) without the need to file an amended federal tax return. This enables the taxpayer to recapture all the depreciation they would have been entitled to as far back as 1987 and claim the “catch up” adjustment (IRC Section 481(a)) in one year!



The Process



It is essential that the CSS be undertaken by a qualified third-party cost segregation consultant. The consultant should have a significant engineering, construction and tax background. It is also imperative that your CPA be involved with the process as well. While there are many accounting firms who profess to have the in-house engineering expertise to provide CSS, the reality is that few do. An engineering-based approach is the only way that a CSS will withstand IRS scrutiny. According to Linda Guendelsberger, tax director for Fishbein & Company, P.C., in Horsham, PA, “There is a lot of value in using a CSS consultant. Many of our clients have benefited from a CSS and they have found the experience with the CSS consultant to be smooth and efficient.”



The process involves the review of relevant property information such as cost data, lease agreements, and building plans. Next the engineers dissect the building costs to re-classify the property in 39 (or 27.5), 15, 7 and 5 year categories. Soft costs, engineering, and builder’s overhead and profit are allocated to the project in accordance with the findings of the CSS.



Generally, the entire process takes four to six weeks and the findings are then integrated with your current accounting and tax information. It is important to emphasize that the engineering approach does not negate the involvement of your CPA as in the case of an existing property already placed in service for which a tax return has been filed. Your accountant will need to re-run the depreciation schedules for the assets identified for shorter depreciation and also prepare any necessary forms such as IRS Form 3115. Guendelsberger adds that “tax planning takes place at every stage of the CSS process and it is important that the CPA be available to review the findings of the study prior to its completion.”



What is the Typical Return?



Typically, cost segregation studies show savings that can equal four to five percent or more of the asset cost. For example, a $5 million property, assuming a five percent benefit, should generate $250,000 in tax savings. Savings of anywhere from $50,000 to $1 million, or more, is not uncommon. It is important to note that a cost segregation study does not increase your depreciation, it accelerates it. The bottom line is that you benefit from having more cash in your hands now that you can put to work in other ways.







Cost Segregation Case Study



The chart below shows a real example of the “before and after” CSS depreciation allocations. The property in the example below is a hotel having a development cost of $3,440,000 which was built in 1998. The property was improved in 2001 for $375,000. The total depreciable basis for the property is $3,815,000.



As shown above, the study identified the “after CSS” and prior yearly depreciation amounts. The IRS allows a taxpayer to go as far back as 1987 (or in this case to 1998, the year it was built) to reclassify property. The benefit to the taxpayer is that the increased depreciation amount from prior years can now be deducted in the next tax year. The chart below shows the impact of the recaptured amounts:



Results:

The graph below shows the property amounts that were originally scheduled as well as those property allocations that were made after the CSS was performed. Prior to the CSS, 39-year property accounted for 100 percent of the depreciable items. The completed CSS shows that our engineers were able to identify and reallocate $1,793,000, or 47 percent, of the assets to shorter depreciation schedules.





The information below shows the financial impact of the CSS in terms of potential taxes saved. Note: The cash (tax) savings were determined by using a blended federal and state tax of 43 percent. The NPV savings calculation was determined using a 6 percent discount rate.

Summary of Results

Accelerated Property $1,793,050

Additional Depreciation $ 834,279

Cash (Tax) Savings for 2003 $ 358,740

NPV Over Years 1 - 10 $ 431,630







Greg K. Bryant, is President of Bedford Capital Corporation. He has over 30 years of experience in the real estate – engineering consulting industries. For more information please contact David Curtis at 704-210-8954 or www.bedfordcap.com