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By Ted Lanzaro, CPA
Commercial real estate owners take note! Cost segregation studies are one of the profitable tax planning strategies in commercial real estate. The study offers a tremendous opportunity to increase cash flow and defer tax payments until later years. Yet, only the most sophisticated certified public accountants know much about this technique and only 15% of commercial building owners have taken advantage of it.
A Cost Segregation Study (CSS) is an engineering based study that allows a commercial building owner to accelerate a substantial amount of the depreciation deductions on a building by identifying construction or acquisition costs that can be allocated to a shorter recovery period. The basic idea is to move costs that would ordinarily be depreciated over 27.5 to 39 years to being depreciated over 5 to 7 years using the IRS approved, engineering based study as proof that the cost should be depreciated over a shorter life.
Let’s look at some situations where this study is appropriate and some examples of how commercial building owners have benefited from such a study.
Generally speaking, this is the easiest type of study to perform because the engineers get involved right from the beginning and have access to the architectural drawings and building invoices. For example, a 4 story office building completed at a total construction cost of $9.6 million. Without the help of an expert CPA and engineer, the building owner would be depreciating the $9.6 million of cost over 39 years.
With a cost segregation study, the engineers come in and examine all the construction invoices and design documents. The engineers do an on-site study where they identify, measure, quantify and photograph the existence of all the assets within the building that qualify for accelerated depreciation.
End Result: By performing the study, the engineers were able to allocate $1.95 million or 20% of the assets to shorter recovery periods and save the property owner over $427,000 in taxes over the first seven years of ownership.
The Cost Segregation Study can also be performed when a commercial property owner acquires a property. Generally speaking, there are two types of these studies:
For example, a local regional shopping mall located was purchased by a real estate investment company. The 2 story mall was purchased for $25.6 million. Without a cost segregation study, the acquisition cost would be depreciated over 39 years.
Upon acquiring the property, the new owners had an engineering based Cost Segregation Study performed. Using whatever initial construction data that was available from the prior owner (sometimes there is no information available) and by performing a detailed on-site evaluation and identification process that included photographing all the assets, the engineers were able to determine which assets were eligible for accelerated depreciation.
End Result: A total of $9.8 million of assets (38% of the total cost) was determined to qualify for either 5 year or 15 year depreciation resulting in a tax savings of $1.5 million over the first 10 years of the property ownership and $250,000 of tax savings in the first year.
When performing a “look-back” study, often none of the construction information is available. A look-back study typically relies on the engineer’s on-site evaluation and identification of qualified assets. However, a property owner doing a “look-back” study can often receive a terrific amount of tax savings in the first year because according to Internal Revenue Code Section 418(a), the property owner is allowed is make an adjustment to catch up on depreciation. The catch up is equal to the difference between what was depreciated and what could have been depreciation had a Cost Segregation Study been performed on day one.
Let’s look at an example:
A small suburban office building was purchased by its owners in 2011 at a cost of $10 million. At this time, the owner’s accountant began depreciating the property over 39 years. The Cost Segregation Study was performed in 2015. The study identified $800,000 of assets that could be reallocated to a 5 year recovery period.
End Result: In 2015, the property owner was allowed a catch up of more than $680,000 of depreciation which resulted in a $238,000 tax savings under Internal Revenue Code Section 481(a).
Both tenants and landlords can take advantage of a Cost Segregation Study when they must invest funds to fit-out a space. A typical Cost Segregation Study can re-allocate over 30% of leasehold improvements, normally depreciated over 39 years, to five and seven year recovery periods. In addition, certain Qualified Leasehold Improvements may be eligible for additional considerations, even retroactively.
An example of this occurred when a high end restaurant, bar and grill leased and built out its space in a shopping mall. The restaurant owners spent over $1.4 million on the custom fit-out of the restaurant space. A Cost Segregation Study was performed by an engineering team that reviewed the construction documents and conducted an on-site evaluation of the construction. Again, assets were identified and photographed by the team and the costs of the identified assets were quantified.
End Result: $924,000 of assets re-allocated (65.2%) to shorter recovery periods resulting in over $236,000 on tax savings over 10 years and $17,000 of tax savings in the first year.
It is easy to see why a Cost Segregation Study in such a powerful tax planning strategy for commercial property owners and even tenants paying for their own fit-outs.
What types of properties can benefit from a Cost Segregation Study?
Examples include office buildings, shopping malls, strip shopping centers, apartment buildings, large leasehold fit-outs, auto dealerships, free standing out parcel buildings used for large retail stores or chain fast food restaurants, hotels and resorts, distribution warehouses, manufacturing facilities and industrial buildings. Any commercial property owner looking to reduce their tax burden should consider this powerful strategy.
For more information about whether a cost segregation study can save you thousands of dollars a year on your taxes, contact CPA Ted Lanzaro by clicking here.