Cost Segregation

Recovering costs to maximize income tax savings

By Paul L. White, CPM®

Every property and asset manager has the responsibility to continually improve the cash flow and value of the assets for which they are responsible. With several federal tax court decisions, we now have a valuable tool for increasing the after-tax cash flow of almost any commercial property. Through using cost segregation studies, owners can accelerate depreciation on many components of their properties over five-, seven- and 15-year life periods.

History

With the passage of the Tax Reform Act of 1986, Congress changed how commercial real estate owners could depreciate their properties from several methods of accelerated depreciation to basically straight line depreciation, with residential properties having a life of 27.5 years and other commercial properties 31.5 years. In 1993, the commercial properties were changed to 39 years. These changes had a significant impact on the after-tax cash flow for owners and contributed to the savings and loan crisis of the late 1980s.

In 1996, Walgreens (Walgreens Co. & Subs. V Commissioner, 103 T.C. 582, 1994) won their challenge before the U.S. Tax Court to the practice of using a 39.5 year cost recovery period for the improvements in their new free-standing stores, arguing that some of the fixtures and improvements in them should be classified with a shorter life.

The IRS acquiesced to this and other similar rulings; however, the judge modified his ruling to state that “in order for the cost segregation study to meet the minimum guidelines, the study had to be completed by individuals competent in construction or building techniques.”

From 1997 to 2004, no clear guidelines existed for engineers to follow in conducting such studies; each study had to be extensive and exhaustive to meet the unknown requirements of the IRS . Few property owners could justify such studies.

In 2004, the IRS issued guidelines on what to look for in a cost segregation study, ultimately eliminating a great deal of unnecessary work for all involved. Cost segregation studies thus became cost effective for owners of both small and large properties.

Cost Segregation Study

Cost segregation studies identify improvements that can be identified as personal property or specific to the use of the property. Depending on the classification of the improvements they may be depreciated typically over 5, 7 or 15 years instead of the normal 27.5 or 39 years. This increased depreciation can have a significant impact on the owner’s taxable income.

For properties developed or acquired since January 1, 1987 , a property owner can have a cost segregation study performed and take the benefit of all prior years’ missed depreciation in the current tax year realizing a potentially huge income tax deferral or even refund. A property owner should review the impact of such a deferral with his tax professional to be sure he understands the savings that can be realized as well as the potential impact of the depreciation recapture tax when the property is sold.

Property and asset managers should review their asset portfolios to determine the potential benefits cost segregation can bring their clients. Potentially every commercial property acquired or built after January 1, 1987 with a depreciable value of $1 million that is going to be held for more than a couple of years could significantly benefit from the resulting accelerated depreciation.

Paul L. White, CPM®, CCIM (paulwhite@plwa.biz), is the director of the Commercial Division for Keller Williams and president of Paul L. White & Associates, a commercial real estate consulting company. White also serves as the 2008 chair of the JPM Editorial Advisory Board.

Source: Nov/Dec 2008 issue (Volume 73, Number 6) of JPM^®, Journal of Property Management.

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