How can I keep more using Cost Segregation?

If you are the owner of commercial real estate and/or have invested in leasehold improvements within the last ten years, you might be sitting on thousands of dollars of untapped cash. Let me show you a strategy for uncovering this cash and applying it immediately to your bottom line.

What is Cost Segregation (CS)?

Consider a purchase of real estate. Real property is typically comprised of four elements:

• The Land

• Land Improvements (sidewalks, landscaping, etc.)

• The Building Structure

• Personal Property (flooring, lighting, etc.)

Cost Segregation (CS) is a strategy whereby the incremental cost of each of these categories is determined so that the categorized items can be depreciated over their respective lives as classified by the IRS. For example, a commercial building has an expected life, for IRS purposes of 39.5 years while a piece of equipment in that building may have an expected life of 5 years. The IRS allows the taxpayer to divide the cost of the property or equipment by its expected life and to deduct that amount from your taxes each year.  By accelerating depreciation on certain components of your property, you are able to maximize your tax deductions to an extent never before allowable.

Why have I not heard of this before?

CS has been around for many years and the landmark decision allowing CS was made in 1997 when HCA challenged an IRS ruling. Since this case, CS has undergone several court challenges and in 2004, the IRS formally accepted CS and issued guidelines for its allowable use.  One of the primary requirements for CS or for a Cost Segregation Study (CSS) is that it MUST be performed by professionals with specific knowledge of construction, construction costs, approved estimating procedures and the relevant tax code. Most accounting firms do not have this expertise and most development firms do not have the tax expertise. While the use of CS by accounting firms is increasing, an estimated 40 percent of allowable deductions are not made due to the lack of familiarity with costing procedures and/or specific property types.

What are the Benefits?

Let’s go through an example to illustrate the benefits. This simple model shows how most real estate transactions are currently treated for tax purposes.

• Assumptions on the purchase of  property for $5,000,000:

• $1,100,000 - Land Value (LV)

• $3,900,000 - Building Value (BV)

• 39 years - Typical Depreciation  Schedule w/o CSS

• 30 percent - Annual Federal Tax rate

The current standard is to divide the Building Value by the Depreciation Rate to get the annual tax deductible expense.

($3,900,000 BV / 39 years = $100,000 annual tax deduction.

Multiply the deduction by the tax rate to show the tax benefit or increase in cash flow.

$100,000 deduction x 30 percent tax rate = $30,000 tax benefit

Here’s an example of the same property when the results of a CSS have been applied:

• Assumptions on the purchase of property for $5,000,000:

• $725,000 - Land Value (LV)

• $375,000 - Land Improvements (sidewalks, landscaping, etc) (LI)

• $1,100,000 - Total Land + Improvements

• $2,765,000 - Building Value (BV)

• $1,185,000 - Building Components (BC)

• $3,950,000 - Total Building + Components

• 39 years - Typical Depreciation Schedule for Building

• 15 years - Depreciation for Land Improvements

• 7 years - Depreciation for Building Components

• 30 percent - Annual Federal Tax rate

Take the Land Improvements plus the Building Value plus the Building Components and divide by their respective depreciation schedules to get the annual deductions for each. Add these together to get the total annual deduction.

• $375,000 (LI) / 15 years = $25,000

• $2,340,000 (BV) / 39 years = $60,000

• $1,185,000 (BC) / 7 years = $169,286

Total tax deduction after Cost Segregation = $254,286

Multiple by the tax rate to get the annual after tax increase in cash flow.

$254,286 deduction x 30 percent tax rate = $76,286 increase in cash flow.

Using CS in the example above, the property owner is able to increase his cash flow by $46,286 per year ($76,286 after CS - $30,000 before CS) or $231,429 over five years.

What items qualify for this accelerated depreciation?

Based upon IRS guidelines,  the most common components for medical properties include cabinetry, special plumbing and electrical, special lighting, cabling and computer wiring, wall coverings and a host of others components.

What are other benefits of a Cost Segregation Study?

Another primary benefit of a CSS is that other components are given a value in the case of  failure. For example, in the case above, if the roof was valued at $395,000 in the CSS and collapses two years later and must be replaced, the entire basis of the roof component can be deducted from your taxes ($395,000 - $20,000 = $375,000). If a CSS had not been completed, you have no way of valuing that component cost.  This is a Tremendous benefit to owners of older properties.

What about Leasehold Improvements?

Leasehold improvements are also subject to the tax advantages bestowed by CS and oftentimes create a tremendous tax advantage.

Are there additional benefits of CS?

Yes, there are numerous benefits to creating a CSS, especially if you are planning renovations to a building, have invested in LEED or green building technologies and/or would like to protect yourself from component failures common to older structures.

What makes a good CSS candidate?

All types of commercial buildings are candidates for CS. The best candidates are healthcare facilities, hotels, restaurants, apartments, retail and manufacturing facilities. The best candidates for CS are those buildings which have been purchased and/or renovated since 1986, are owned by taxpayers or for-profit companies and/or which have undergone significant renovations.  Based upon this criteria, there are many physician/owners able to recoup significant sums of money or to establish a cost basis to use from this day forward.

What are the attributes of a Cost Segregation team?

Your CS team should be experts in three key fields: the tax code, building construction and estimating methods and specifics about medical facility design and construction.  By utilizing a team of experts with this background, you can maximize your deductions while minimizing your tax exposure.

Will using a CSS increase my chances of being audited by the IRS?

No, CS is approved with issued guidelines for implementation. The basic outline of the study is strongly encouraged and if the preparer’s of the study have sufficient credentials, the IRS field agents have been directed to approve without dispute after cursory review.

In conclusion, the professionals at Healthcare Realty & Development recommend that you investigate the benefits of having a Cost Segregation Study prepared by asking your tax preparer or contacting us directly. For specific information about CS, please visit the IRS website which offers a great deal of information and background, including their suggested guidelines.

Frank Ricci is a Principal with Healthcare Realty and Development Services, specialists in healthcare real estate advisory, brokerage & development services. He can be reached at healthcarerealtyservices@gmail.com

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