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Certified Public Accountant



Guest Post of the Month for July 2003

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Are You Overlooking a 6 Figure Tax Break?
Save on Taxes with Real Estate Cost Segregation
Dave Massoth

If you own a building with a value greater than $1,000,000 or you own a number of facilities that collectively exceed this threshold, this article is important to you.

After careful research and examination, we have determined that significant tax savings can be achieved by accelerating income tax depreciation deductions permissible only recently by the IRS Procedures 2002-18 and 2002-19.

Valuable Tax Savings Imbedded in Buildings

The IRS permits the acceleration of depreciation of some assets that traditionally would be imbedded into the cost of buildings. In essence, they are allowing us to carve out shorter-lived assets (qualifying for 5,7, and 15 year write-off periods) that are normally imbedded in a building’s construction or acquisition costs (generally depreciated over 39 years). To meet IRS acceptance rules, an engineering-based cost segregation study must be conducted and used to justify the accelerated depreciation.

A cost segregation study involves identifying and properly reclassifying the capital amounts allocated to tangible personal property, other tangible property (i.e., IRC Section 1245 property), and land improvements from building costs.

You can "mine out" these buried savings from:

  • New buildings presently under construction.

  • Existing buildings undergoing renovation, remodeling, restoration, or expansion.

  • Prior Purchases of existing property.

  • Office/facility leasehold improvements and "fit outs".

  • Post-1986 real estate construction, building acquisitions, or improvements where no cost segregation study was performed (even though the statute of limitations previously closed on the property construction/acquisition year).

Profit from the benefit of cash flow savings! For every million dollars of property you reclassify for faster depreciation write-offs, the present value of your increased cash flow from income tax savings approximates $230,000.

What Types of Assets Have Shorter Write-Off Periods?

Generally speaking, assets that are an accessory to a company’s business process are not considered part of the building itself and can be carved out for shorter tax write-off periods. Look at how a building is actually put together based on the company’s industry to get a sense of which assets of a building are really related to the company’s business process.

For example, the following assets can normally be carved out:

  • Security systems

  • Phone and intercom systems

  • Emergency back-up generators

  • Site improvements

  • Carpeting

  • Kitchen equipment

  • Computer room access flooring

  • Computer cabling and receptacles

  • Identity signage

  • Removable wall coverings

  • Vinyl composite tile

  • Dry sprinkler systems

  • Special plumbing, electrical and HVAC

  • Woodwork such as built-in cabinetry

  • And many others.

In a cost segregation study, look at each component of property and ask, What separates this from being part of the building or a structural component? The assets function or ultimate use helps determine if it is needed to provide services required by the company’s business process.

Enjoy the Windfall For Real Property Built or Acquired Previously

You now have a valuable opportunity, courtesy of the IRS, if you constructed or purchased real estate in a prior year but did not take advantage of a cost segregation study. This IRS gift horse allows you to prospectively deduct (over one year period) depreciation amounts that you were legally entitled to but did not claim (e.g., due to erroneous property classification as a 39-year depreciable building).

This cash flow windfall is available to you even though the statute of limitations previously closed on the property construction or acquisition year.

Light Manufacturer acquired a facility four years ago for $6 million. Based on the cost segregation analysis, engineers determined that 30% of the building qualifies for short-life classification. By performing the cost segregation study, and filing required accounting method change documents, the manufacturer creates present value cash flow savings from tax reduction approximating $310,000!

A Solid Case for An Engineering-Based Approach

Cost segregation is not new per se. In fact, CPA firms have been doing them for years. The difference is that the IRS has changed the rules. They will no longer accept the accounting-based cost segregation methods commonly used by traditional CPA firms.

The IRS wants engineering-based cost segregation studies that have indisputable evidence for the tax savings. A cost segregation analysis should be based upon all construction documents and physical examinations not just invoices. A complete “audit trail” traces derived unit costs from contract documents and other source data.

Can My General Contractor Do the Study?

Cost segregation is a highly specialized segment of tax law. The volume of judicial decisions, IRS rulings, regulations, and other interpretations span thousands of pages of text. The challenge is to apply this complex knowledge to the unique facts of your industry, your company’s circumstances, and the processes of your operation. That is why we recommend the use of Cost Segregation specialists who have conducted thousands of cost segregation studies throughout the United States.

Why take unnecessary risks? A General Contractor doesn’t understand tax laws and is not likely to have the expertise to do this properly. In addition, this is not their main line of work and may only offer a sub par service as a sales tool. This means that they will likely leave valuable tax benefits "on the table". Moreover, the foregoing will likely not withstand IRS examination.


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