Jay Sachetti joined Jeff O’Brien, partner at Husch Blackwell and Dyanne Ross-Hanson, president of Exit Planning Strategies talked about the market for mergers and acquisitions, exit planning opportunities for companies that don’t end up for sale and how companies can maximize their eventual sale price during an early October panel at the first Upsize on Tap event at Summit Brewing Co. in St. Paul.
When the state Legislature passed a law requiring employers to provide paid leave and safe time for employees, Justin Bieganek started hearing differing details from friends, colleagues and peers.
business builder accounting
by Timothy Kenyon
In the current economic climate it is more important than ever for taxpayers to take advantage of every possible tax break. A frequently asked question that we hear from our clients is, “What else can I write off?”
If you own a commercial or residential rental real estate property, the answer may be a cost segregation study. Although cost segregation studies have been a tool in property valuation arsenals 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 Corp. of America, 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 tax dollars for clients that own or lease real estate.
Practitioners have been doing depreciation analyses for years, identifying specific items such as 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.
Typically, the cost of commercial real estate is depreciated over 39 years and residential real estate is depreciated over 27.5 years. Both commercial and residential real estate is depreciated using the straight-line method. A properly conducted cost segregation study will result in the identification of shorter-lived assets that are included in the “lump-sum” cost of a commercial or residential building.
For tax purposes, these shorter-lived assets are shifted from 39- or 27.5-year depreciation periods to 5-, 7- or 15-year depreciation lives. Certain soft costs can also be allocated to shorter-lived assets. A real estate owner will enjoy greater depreciation deductions and faster write-off of costs that formerly would have been included as part of a building.
It is simple for a building owner, contractor or CPA to identify some of the shorter-lived assets. However, only a qualified engineer or architect experienced in conducting cost segregation studies is able to properly identify all costs related to a property.
Cost segregation studies that result in 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.
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 (for example, bolted rather than welded onto a concrete slab, which would allow for periodic replacement). This piece of personal property might be overlooked if taxpayers do not conduct an on-site inspection.
Studies of existing facilities 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 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 health care facilities. Specialized cost segregation studies for manufacturing and hotel projects can result in a taxpayer classifying up to 40 percent of total construction costs as nonstructural.
In general, cost segregation studies make sense if:
• Your property cost is at least $1 million;
• You are in a high tax bracket;
• You have owned the property for 10 years or less.
Usually benefits are greatest if you meet these conditions. Return on investment is generally greater as the cost of the subject property increases. The benefits of a cost segregation study are derived from tax savings, which result in improved cash flow. It all boils down to a simple time value of money issue. Therefore, a study will not make sense if you are in a low tax bracket or if you pay no tax (e.g. you have a net operating loss).
The longer you own a property, the more cost you will recover through depreciation expense. However, even though you may have owned a building for several years you can still take advantage of missed depreciation deductions for prior years. The Internal Revenue Code and regulations allow for “catch up” of those missed deductions by filing an application for change in accounting method with the IRS.
The IRS will automatically consent to the change, and because of a recent revision in the regulations you can deduct the “catch up” entirely in your current tax year. This creates the potential for a deduction of hundreds of thousands of dollars in one year depending on the cost of the property and time period involved.
It’s simple for a CPA working with an engineer to calculate the potential savings that you may realize on a cost segregation study. Cost segregation studies have always been a great way to keep cash in your pocket and out of the IRS’s hands. The current change to the regulations is a gift that makes cost segregation studies better than ever.
Timothy Kenyon is a certified public accountant and tax partner with Cummings, Keegan & Co. in St. Louis Park, which helps businesses and individuals with tax, accounting and business management services: 952.345.2500; tk*****@******pa.com; www.ckco-cpa.com
