The advantages of a Cost Segregation Analysis for commercial buildings
Whether you are constructing a new building, remodeling a current facility, or purchasing a building, property asset classification for depreciation purposes are an often overseen tool to save tax. In a cost segregation analysis, the real estate assets eligible for more rapid depreciation are identified and segregated. The result? You may save thousands of dollars in after-tax income.
After the courts ruled in 1986 that commercial property cannot be depreciated rapidly, but over a time span of 39 years, the U.S. tax court revised the ruling in 1997 and advised that cost segregation studies are allowable to distinguish tangible property from real property with the goal of quicker deprecation for asset classes other than real property. The court also determined, that cost segregation studies will be applicable retroactive for real property purchased, constructed, expanded or remodeled since 1987.
Analysis of capital expenditures is used to determine appropriate asset classifications. Cost segregation identifies building costs that would typically be depreciated over a 39-year period and reclassifies them to permit a shorter, accelerated method of depreciation for certain building costs. Costs for non-structural elements, such as wall covering, carpet, accent lighting, portions of the electrical system, and exterior site improvements such as sidewalks and landscaping, can often be depreciated over five, seven or 15 years, rather than over 39 years.
A study is typically cost-effective for buildings purchased or remodeled at a cost greater than $400,000. A cost segregation study is most efficient for new buildings recently constructed, but it can also uncover retroactive tax deductions for older buildings, which can generate significant short benefits due to “catch-up” depreciation.
Each $100,000 in assets reclassified from a 39-year recovery period to a five-year recovery period results in approximately $16,000 in net-present-value savings, assuming a 5% discount rate and a 35% marginal tax rate.
Furthermore the benefits include:
– Increased cash flow with accelerated depreciation; federal and state tax liabilities can be reduced
– Cost Segregation Studies can assist in reducing real estate tax
– A segregation into assets can reduce insurance costs
How is a Cost Segregation Study prepared?
There are several approaches, ranging from very detailed to a “Rule of Thumb” approach. In my opinion, the only applicable approach is the “Detailed Engineering Approach from Actual Cost Records” when a newly constructed building is evaluated and the “Detailed Engineering Cost Estimate Approach” for existing buildings:
1. Detailed Engineering Approach From Actual Cost Records
The detailed engineering approach from actual cost records, or “detailed cost approach,” uses costs from contemporaneous construction and accounting records. In general, it is the most methodical and accurate approach, relying on solid documentation and minimal estimation. Construction-based documentation, such as blueprints, specifications, contracts, job reports, change orders, payment requests, and invoices, are used to determine unit costs. The use of actual cost records contributes to the overall accuracy of cost allocations, although issues may still arise as to the classification of specific assets.
This approach is generally applied only to new construction, where detailed cost records are available. For used or acquired property and for new projects where original construction documents are not available, an alternative approach (e.g., the “detailed engineering cost estimate approach”) may be more appropriate.
The detailed cost approach typically includes the following activities:
1) Identify the specific project/assets that will be analyzed.
2) Obtain a complete listing of all project costs and substantiate the total project costs.
3) Inspect the facility to determine the nature of the project and its intended use.
4) Photograph specific property items for reference. Request previous site photographs that illustrate the construction progress as well as the condition of the property before the project began.
5) Review “as-built” blueprints, specifications, contracts, bid documents, contractor pay requests, and other construction documentation.
6) Identify and assign specific project items to property classes (e.g., land, land improvements, building, equipment, furniture and fixtures, and other items of tangible personal property).
7) Prepare quantitative “take-offs” for all materials and use payment records to compute unit costs.
8) Apply unit costs to each project component to determine its total cost. Reconcile total costs obtained from quantitative take-offs to total actual costs.
9) Allocate indirect costs, such as architectural fees, engineering fees, and permits, to appropriate assets.
10) Group project items with similar class lives and placed-in-service dates to compute depreciation.
The detailed cost approach is the most time consuming method and generally provides the most accurate cost allocations. However, the examiner should recognize that the proper classification and costs of § 1245 property could still be an issue with this method.
2. Detailed Engineering Cost Estimate Approach
The detailed engineering cost estimate approach (or detailed estimate approach) is similar to the detailed cost approach. The difference is that the detailed estimate approach estimates costs, rather than using actual costs. This approach is used when cost records are not available or for an acquisition when the purchase price must be allocated.
The detailed estimate approach is methodical, relying on solid documentation and utilizing construction-based documents such as blueprints, specifications, contracts, job reports, change orders, payment requests, invoices, appraisals, etc. When estimates are required, they are based on costing data, either from contractors or from reliable published sources (e.g., R. S. Means or Marshall Valuation Service). The sources of estimating data are clearly referenced, including identification of the specific volume, page, and item number. Further, the same estimating techniques and unit cost data sources are used for all of the items that comprise the actual cost.
In essence, the steps for this approach are the same as the detailed cost approach, except for Step 7 (in which costs come from contractor estimates or estimating guides). However, if detailed cost estimates are prepared by qualified individuals, and the estimates are reconciled to actual costs, then reasonably-accurate cost allocations are possible.
The 13 principal elements of a quality study are:
1) Preparation By An Individual With Expertise And Experience
2) Detailed Description Of The Methodology
3) Use Of Appropriate Documentation
4) Interviews Conducted With Appropriate Parties
5) Use Of A Common Nomenclature
6) Use Of A Standard Numbering System
7) Explanation Of The Legal Analysis
8) Determination Of Unit Costs And Engineering “Take-Offs”
9) Organization Of Assets Into Lists Or Groups
10) Reconciliation Of Total Allocated Costs To Total Actual Costs
11) Explanation Of The Treatment Of Indirect Costs
12) Identification And Listing Of Section 1245 Property
13) Consideration Of Related Aspects (e.g., IRC § 263A, Change In Accounting Method And Sampling Techniques)
(The forgoing information was taken from the IRS Study Advisory for Cost Segregation Studies)
If performed right, and in close cooperation with a knowledgeable CPA, a Cost Segregation Analysis can be a real tax saver. Make sure, the analysis is prepared by a qualified appraiser and based on the IRS Study Advisory.
If your commercial building is in excess of $400,000, consult your CPA to determine if you could tap the hidden reservoir of cash in your commercial property.
Share this Post