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Have you recently constructed a new facility or purchased a building? Have you considered how the costs of the building will be recorded on your books? Perhaps you have taken it for granted that all the costs should be recorded as “building”, and depreciated over 39.5 years for income tax purposes. This is simply not the case. Most real property owners can benefit significantly from completing a cost segregation study to provide a basis for allocation of costs to assets other than “building”.
A carefully researched and documented cost segregation study can enable commercial property owners to significantly improve their investment returns by currently:
• Reducing federal income taxes
• Increasing after-tax cash flow
• Increasing debt service ability
How Does Cost Segregation Work?
Cost segregation can identify and classify costs to acquire, construct or expand commercial real properties such as office buildings, or manufacturing or distribution facilities. The objective of cost segregation is to properly classify costs into the correct categories for tax depreciation purposes. Based upon the Internal Revenue Code, Revenue Rulings, case law and Private Letter Rulings, a cost segregation study should support classification of the assets being placed in service into their appropriate categories for tax depreciation purposes. Assets that should have depreciable tax lives shorter than the 39.5 years, typical for real property, can thereby be identified and accounted for.
It is generally relatively easy to identify, and properly depreciate, items such as office furniture and equipment. Classification of buildings and building components is not so obvious. And, many owners do not know that a significant portion of their construction, or acquisition costs, can meet the tax requirements to be classified as into a category other than “building”. These re-categorized costs can then be depreciated over fewer years (e.g. 5, 7 or 15 years), thereby allowing the tax benefits to be recouped sooner. Unfortunately, all too often all real property construction and acquisition costs are lumped into building for tax and accounting purposes and depreciated over the longer recovery period. The table below illustrates the potential benefits from a cost segregation study on several different types of commercial properties. The average potential tax savings are typically about 1 to 1.5 percent of the cost of an office building up to 3 to 3.5 percent of the cost of a manufacturing or distribution facility.
When is the Best Time to Perform a Cost Segregation Study?
The ideal time to initiate a cost segregation study is prior to beginning construction, when there may be more flexibility to explore tax and construction planning options. Design changes may make it possible to achieve greater tax benefits without dramatically changing the overall aesthetic appeal, appearance or business functionality of the property.
But even though a cost segregation study can be started as early as the beginning of the design process, studies can be done to the owner’s advantage as late as several years after the completion or acquisition of the property.
What is Required to do a Cost Segregation Study?
Typically, a physical review of the property is the starting point. This is followed by a comprehensive review of the following items and documentation: a complete set of construction plans; current tax depreciation records; budgeted building cost information; final AIA application and documentation of certification for payment or other cost information; change order detail, direct or indirect costs paid by the owner not included in other documentation; and other relevant information depending upon the project.
Additional Depreciation Benefits Allowed Through December 31, 2004
In 2003, the President signed into law the Jobs and Growth Tax Relief Reconciliation Act. The Act contained provisions creating a one-time 50 percent immediate depreciation deduction for certain “Stimulus Eligible” property placed in service after May 5, 2003, and before December 31, 2004. The Act allows this 50 percent depreciation write-off for all qualifying property in addition to the regular first year’s depreciation percentage. Qualifying property includes most business property and software that is not categorized as buildings. Therefore, cost segregation can be of further benefit by properly allocating costs to assets that are eligible for this stimulus benefit. By identifying all “stimulus eligible” property through a cost segregation study, business owners may increase the tax benefits available during the Stimulus Act eligibility period. As you can see from the table, the current tax benefits of Stimulus Eligible property can be significant. The additional incremental benefit from the cost segregation study should average about one-half of one percent of the cost of the project.
Quantifying the Benefits
If a cost segregation study has not been performed in conjunction with your most recent construction or property acquisition, significant tax benefits may be going unclaimed. Does it really make sense to leave those tax benefits on the table? Also keep in mind that no tax returns are required be amended. If you believe you could benefit from a cost segregation study, or would just like to explore the feasibility and cost-effectiveness of having such a study performed, PKF Texas would welcome the opportunity to talk with you. Del Walker (dwalker@pkftexas.com) is available for an initial consultation to discuss the potential benefits of a cost segregation study to you or your business. You can contact them at the email addresses above or by phone at (713) 860-1400.
Del Walker is the practice leader for the Tax Department of PKF Texas.
