Real Estate Investors Can Benefit from Cost Segregation Studies

CPA Journal, The, Jul 2006 by Gonzalez, Julio P

Many real estate investors and business property owners are improving cash flow and finding immediate tax savings from their business properties. Through cost segregation studies (CSS). they are taking advantage of the significant tax benefits from accelerated depreciation deductions for commercial and investment properties. Supported by more than 200 court cases, Treasury regulations, and IRS revenue rulings, the time-tested methodology of cost segregation is a generally accepted tool available to substantially reduce income taxes by increasing depreciation allowances.

CSSs are an IRS-sanctioned technique that allow businesses to accelerate depreciation on their facilities. Although the IRS does not prescribe one specific methodology, the IRS's Cost Segregation Audit Technique Guide enumerates several methods and considers the detailed engineering approach from actual cost records as "the most methodical and accurate approach." This approach consists of carefully examining all contemporaneous construction and accounting records. Estimates or "take-offs" are used to supplement the actual cost detail when the existing detail is not sufficient for the study. A professional consultancy comprised of architects, engineers, and accountants with prior cost-segregation experience is required to perform this kind of cost segregation study.

By recovering costs over a shorter period of time, property owners can enjoy substantial tax savings. In accordance with the Modified Accelerated Cost Recovery System (MACRS), case law, and various IRS revenue rulings, the study allocates total building costs between IRC section 1250 real property (27.5-39-year life) and IRC section 1250 personal property (5-15-year life). The reallocated personal property typically amounts to 15% to 35% of the total construction costs. Depending on the type of property, this percentage can be higher. Additionally, property owners may also find state and local real estate tax savings from the cost segregation study. The example in the Sidebar illustrates the benefits of depreciation using cost segregation over the traditional and conventional (much more costly) method.

Converting the Gain to Cash

In the example in the Sidebar, using the CSS alternative would have reduced taxable income by $1,307,692, for a cash savings of $457,692 at a 35% tax rate. If the building was placed into service in prior years, a taxpayer could amend prior-years returns for a refund, or could take an IRC section 481 (a) catch-up to reduce taxable income in the year of the CSS. For a new building being placed into service in the same year as a CSS, the cash savings using the CSS method over straight-line would be $91,538.46 per year.

Over the past five years, CSSs have dramatically decreased in price. Once the province of only the largest CPA firms, CSSs are cost effective for small to medium-sized businesses as well. Simply stated, with a benefit-to-cost ratio that typically exceeds 10:1, the value of the tax deferral more than justifies the fee.

History of CSS

The process of identifying assets within an investment property for accelerating depreciation has been around for many years. Courts have ruled in favor of this tax strategy since 1959 (Stiainberg v. Commissioner) to account for the natural exhaustion, wear and tear, and obsolescence of property used in a trade or business. Whether it was referred to as an investment tax credit (ITC), component depreciation, or cost segregation, the primary objective has always been increased cash flow. The ITC and component depreciation were eliminated and replaced by MACRS under the Tax Reform Act of 1986. Cost segregation stemmed from taxpayers following MACRS without a methodology prescribed by the IRS. Most practitioners relied on methodologies similar to those used under the ITC.

In 1997, the U.S. Tax Court ruled in favor of the Hospital Corporation of America (HCA v. Commissioner), signifying a landmark decision for cost segregation. The court ruled that IRC section 1245 property is to be broadly construed in the same manner as section 38 property under the ITC, and that the "component depreciation" prohibition does not apply to section 1245 building components, but rather only to section 1250 building components. The IRS acquiesced to HCA, holding that the ITC tests may be used to identify IRC section 1245 property. Finally, CSS must provide a logical and objective measure of the reclassified property that should be closely scrutinized. Since then, numerous court cases and revenue rulings have legitimized this tax-savings strategy.

When to Perform a CSS

Although a CSS can be performed at any time, one should be completed in or near the year that a building or improvement is placed in service. This allows for a thorough examination of contemporaneous constructive documents and maximizes the tax-deferral benefits from the study.

Owners who failed to perform a CSS in prior years may still benefit from having a study conducted. They may catch up on the depreciation that should have been taken in previous years, known as an IRC 481 (a) adjustment. The IRS now allows IRC section 481 (a) adjustments to be claimed entirely in the first year; previous rulings required taxpayers to spread the catch-up over a four-year period.