TAX STRATEGIES FOR REAL ESTATE
Cost Segregation Analysis
When a real property asset is acquired, many taxpayers allocate the acquisition cost between building and land using some arbitrary ratio such as “80/20.” However, some of the acquisition cost is likely attributable to various nonstructural assets such as electrical distribution systems, exhaust systems, carpeting, vinyl wall and floor coverings, sidewalks, parking lots, landscaping, and so on and so forth. A Cost Segregation Analysis is the process of classifying a property’s acquisition cost into these various asset categories for purposes of computing tax depreciation.
In general, a Cost Segregation Analysis classifies a property’s acquisition cost into one of four main asset categories: (i) personal property, (ii) building, (iii) land improvements, and (iv) land.
Because personal property and land improvement assets have much shorter depreciable lives and more accelerated depreciation methods than the building category, segregating property assets into the different categories maximizes the tax depreciation deduction.
That sounds easy, why do I need a tax professional?
While the idea of cost segregation sounds simple enough, in practice it generally involves examining blue prints, understanding tax asset classification categories, conducting a cost-benefit analysis and writing a detailed report sufficient to support the analysis conclusions in accordance with IRS guidelines. Accordingly, depending on the size, composition and location of the property, a cost segregation analysis can be a significant, time-consuming endeavour. Without the requisite expertise, the cost of the analysis could be more than the benefit.
Assume Pinnacle Office Partners, LLC (“Pinnacle”) acquires an office building on January 1, 2010 for $1.5 million and allocates 20% of the cost ($300,000) to land and 80% ($1.2 million) to building. Without undertaking a Cost Segregation Analysis, Pinnacle would probably treat the property like most taxpayers and simply depreciate the $1.2 million building cost on a straight-line basis over 39 years resulting in a tax depreciation deduction of approximately $30,770 per year.
However, if Pinnacle undertakes a cost segregation analysis, it may be able to reclassify some of the land and building costs into different asset categories to obtain an increased tax depreciation deduction. The table below illustrates a hypothetical cost segregation analysis for Pinnacle’s office building acquisition and compares the 1st-year depreciation before and after the analysis. The “Before Cost Segregation” columns show the basic allocation (80% to building and 20% to land) and the “After Cost Segregation” columns show the reallocation of the land and building costs to various asset categories. As a result of the Cost Segregation Analysis, $59,000 of the nondepreciable land cost was reallocated to depreciable land improvements including sidewalks, landscaping, a parking lot and a fence. These assets are depreciated over 15 years using the 150% double-declining balance method of depreciation. In addition, $272,000 of building cost was reallocated to 5-year category assets and depreciated using an accelerated depreciation method under the Modified Accelerated Cost Recovery System. Based on this analysis, by undertaking a Cost Segregation Analysis, Pinnacle could increase its depreciation deduction in just the first year by $50,376.
Elements of a Quality Analysis
Although there are no legal standards pertaining to cost segregation analyses, the Internal Revenue Service has provided guidelines to its revenue agents for use in conducting an audit examination of a cost segregation study. According to these guidelines a “quality” cost segregation study is one that will expedite the Service’s review process and minimize the audit burden on all parties.
In that sense, a quality cost segregation analysis must be accurate and well-documented with respect to the following components:
- Proper classification of assets (e.g., land, land improvements, building, equipment, furniture and fixtures);
- Explanation of the rationale (including legal citations) for classifying assets as either Section 1245 assets (personal property) or Section 1250 assets (real property); and,
- Substantiation of the cost basis of each asset and reconciliation of the total allocated costs to the total actual costs.
Principal Elements of a Quality Cost Segregation Study
The IRS guidelines provide that the 13 principal elements of a quality cost segregation study are as follows:
- Preparation by an Individual with Expertise and Experience
- Detailed Description of the Methodology
- Use of Appropriate Documentation
- Interviews Conducted with Appropriate Parties
- Use of a Common Nomenclature
- Use of a Standard Numbering System
- Explanation of the Legal Analysis
- Determination of Unit Costs and Engineering “Take-Offs”
- Organization of Assets Into Lists or Groups
- Reconciliation of Total Allocated Costs to Total Actual Costs
- Explanation of the Treatment of Indirect Costs
- Identification and Listing of Section 1245 Property
- Consideration of Related Aspects (e.g., IRC § 263A, Change In Accounting Method And Sampling Techniques)
While an increased depreciation deduction is certainly the main benefit of a cost segregation analysis, many do not realize the magnitude of the benefit.
Although cost segregation is typically undertaken during construction or at the time of purchase, it can also be implemented with respect to property that was acquired years ago. In this case, a Cost Segregation Analysis can be used to correct prior-year mistakes and therefore cumulatively “catch-up” missed depreciation deductions all at once. Such cumulative adjustments can be significant depending on the number of years and type of assets involved.
Moreover, a Cost Segregation Analysis can permit taxpayers to take advantage of favorable changes in the law that they might otherwise have missed if the time for filing an amended return has already passed. For example, if a building was placed into service in 2008, a Cost Segregation Analysis would likely result in the reclassification of real property into asset categories that may qualify for 50% or even 100% bonus depreciation even if such analysis is undertaken several years later.
Other Benefits of Segregating Costs
A cost-segregation study may also provide insurance cost savings and estate planning advantages. By providing a cost-segregation report to your insurance underwriter, the insurance company can better understand and focus on its risk, and more accurately underwrite the insurance cost.
Using a cost-segregation study in the estate planning process can create the opportunity to accelerate the depreciation on the same property at its original cost and then again at its stepped-up basis upon the death of the owner.