CREATING RAPID DEPRECIATION RESULTS
BUILDING OWNERS, ARE YOU NEEDLESSLY giving away money to the IRS? If you own a building that costs more than $750,000 purchased after 1986 and have not commissioned a cost segregation study, you very likely are forfeiting thousands of dollars in lost depreciation savings.
General contractors, do you want to increase your sales? Why not increase your closing-ratio average by creating value for your customers by providing a cost segregation study with the purchase of each new building from your firm? Once your prospects understand the incredible, fully legal benefits of cost segregation, they will be beating a path to your door.
In addition to providing a cost segregation study, a thoughtful builder can preplan the design of a building with an eye toward improving rapid depreciation write-off opportunities. Once again, as a builder, you are creating tangible and intangible goodwill with your prospect; a prospect that is much more likely to become a customer for life because of your thoughtful consideration.
WHAT IT IS
What exactly is this cost segregation stuff? Cost segregation is the ability to separate, or segregate, a building's cost by its component costs as determined by each part's estimated life in the eyes of the IRS, whether they should be five, seven, 15 or 39 years or land value, which cannot be depreciated. By separating the individual component costs by depreciable lives instead of depreciating the cost of the entire building over 39 years, the building is more rapidly depreciated.
The resulting rapid depreciation, if done in accordance with IRS standards, will have many desirable results, including:
1) Reduced taxes
2) Increased cash flow
3) Improved return on investment
4) Reduced real-estate holding costs
The proportion of assets that can be segregated will vary depending on many building factors, but a rough outline of expected segregation opportunities follows:
Apartments-10 to 30 percent
Grocery stores-20 to 30 percent
Hotels-20 to 30 percent
Manufacturing facilities-20 to 50 percent
Office buildings-5 to 20 percent
Restaurants-20 to 30 percent
Retail stores-5 to 25 percent
Warehouses-10 to 30 percent
About each $100,000 of assets reclassified from a 39-year recovery period to a five-year recovery period will result in about $16,000 in net-present-value savings, assuming a 5 percent discount rate and 35 percent marginal tax rate. If a $5 million building only has 10 percent of its assets reclassified to five-year assets, the resulting $80,000 worth of additional depreciation can reduce taxes by $28,000.
It is important to note a cost segregation study cannot be based on "reasonable estimates" of property value. Specifically, in a chief counsel advisory (CCA) the IRS warned taxpayers that an "accurate cost segregation study may not be based on non-contemporaneous records, reconstructed data or taxpayers' estimates or assumptions that have no supporting records" (CCA 199921045). Instead the IRS has issued the Cost Segregation Audit Techniques Guide for its auditors and says a cost segregation study using "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."
About each $100,000 of assets reclassified from a 39-year recovery period to a five-year recovery period will result in about $16,000 in netpresent-value savings.
It should be noted the IRS has not issued "brightlines" guidance on which assets are five-, seven-, 15- or 39-year assets. In absence of specifics, the IRS has issued wide guidelines that require a knowledgeable cost segregation expert to interpret accordingly.
A cost segregation study must be performed in compliance with the IRS' most "accurate approach," and this generally means the most accurate approach would require the employment of a professional engineer that would produce the requisite documentation. By utilizing this method, the likelihood of an IRS audit is greatly reduced and, even if audited, the outcome should be satisfactory.
Most cost segregation studies can pay for themselves two or 10 times over in the first year.
A proper cost segregation study requires the following steps:
- Inspection of the property
- Review of architectural and engineering drawings and building specifications with an eye toward asset reclassification
- Inspection of all cost data that may be available on the contractor's application of payments; change orders; and other ownerincurred costs and indirect disbursements, including those costs incurred under contract to other parties that may be related to the construction process
- Itemization of property qualifying for shorter-life classification based on relevant income-tax authorities rulings and guidelines via the professional engineering study
- The prorationing of direct labor, material components and indirect costs based on engineering drawings, specifications and other documents
- Reconciliation of total costs per the engineering study with recognized cost estimating to capitalized project costs
A cost segregation study will rapidly recoup the initial analysis investment. In fact, most cost segregation studies can pay for themselves two or 10 times over in the first year alone.
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