Real estate owners utilize cost segregation studies to capture significant tax benefits

Real estate owners and investors can use cost segregation studies to accelerate overall property depreciation, which can produce a current income tax benefit. This tax benefit applies to commercial, industrial, multifamily, and special purpose real estate. Typically, the more specialized and costly the property, the greater the tax benefits. Often, these benefits are neither captured nor maximized by many real estate owners, because they neglect to have a cost segregation study done on their property.

Cost Segregation Study

A cost segregation study is a comprehensive analysis of the total cost or value of building and site improvements. Cost segregation studies typically do not include analyzing the value of land, furniture, fixtures, and equipment. These studies apportion the value or cost of all specific components of the building and site improvements to certain specific federal tax depreciable life categories. To optimize the reclassification from longer lives to shorter lives, a detailed analysis of the property is required. Qualified engineers and appraisers typically perform these analyses. An understanding of specific tax guidelines and regulations, tax court cases, revenue rulings, and current legislation is required to conduct such studies. Cost segregation studies should be utilized for any taxpayer who constructs a building, acquires a property, expands an existing facility, or changes the tax basis of real property. In addition, cost segregation studies can be conducted on properties constructed or acquired in the past, even if no cost segregation study was performed at the time the property was placed in service.

Methodology

Generally, cost segregation methodology requires establishing a complete and thorough understanding of the total cost or value of the real estate asset in order to determine the total depreciable tax basis. Accomplishing this requires a detailed accounting of the cost of land, site 'improvements, buildings, and equipment in use at the real estate. In new construction, further details of construction cost information, both direct and indirect, are typically utilized for the building. "Direct costs" are costs for labor and materials necessary to construct the asset. "Indirect costs" are items that are required for the project, but not directly associated with specific labor and materials. Some examples of indirect costs include architectural and engineering design fees, contractor overhead and profit, permit fees, and construction interest. These indirect costs are allocated to direct costs on a pro rata basis.

Next, the cost segregation analyst inspects the property to gain a full comprehension of the function, nature and operation of the various building components. The analyst must also confirm the accuracy of the construction or property documents. This is critical in determining the specific property classifications that are associated with depreciable federal tax lives. It establishes appropriate property units by asset function. The central and most significant step in the cost segregation study is the specific identification and quantification of the asset components that qualify for five-year, seven-year, or fifteen-year depreciable tax lives. Often, for newly built property, detailed construction cost information can provide a breakdown of the various costs. A cost segregation study analyzes and supplements the cost information with "quantity take-off estimates" that serve to reclassify even more property into a shorter tax life. Quantity take-off estimating must follow generally accepted engineering and cost estimating procedures. These procedures include the estimation of material and labor quantities and the determination of cost estimates from recognized construction estimating sources or other supportable sources.

The last step in a cost segregation study is to document and report the findings. Generally, the identification and quantification process is supported with documentation and calculations. These are typically referenced by use of an automated, cost segregation, computer based report. This report provides a description of the property, the steps taken to determine the quantification and property life determination and the supporting detail. The analysis procedures require that a consistent, logical and supportable report be produced. There are a number of other supporting and related calculations that are also part of the process. A well conducted study always includes a detailed, referenced, workpaper file, which supports the final conclusions of the study, and also provides an audit trail. When similar property portfolios exist, a sampling methodology may be applied to support the analysis.

Tax Issues

As part of MACRS, non-residential real properties are depreciated over 39 years via straight-line depreciation. Some assets, which are often classified as real property, however, may be depreciated over five or seven years, if they are non-structural components. These assets are defined under section 1245(a)(3) of the Internal Revenue Code as "Personal Property." Yet, there is no specific definition of "personal property." Treas. Reg. [sections] 1.48-1(c) defines the term "tangible personal property" as "any tangible property except land and improvements thereto, such as buildings and other inherently permanent structures, including items which are structural components of such buildings or structures." Several factors were determined in Whiteco Industries, Inc. v. Commissioner, 65 T.C. 664 (1975), to constitute whether property is inherently permanent. These factors include:

* Moveability of the property

* Permanency of design or construction

* Expected length of affixation

* Significance of removal

* Extent of damage if removed

* Manner of affixation

Also, the reusability of the property needs to be considered in the determination.

A significant tax case, Hospital Corporation of America, 109 T.C. 21 (1997), provides guidance for determining tangible personal property. The court concluded that property, which qualified as tangible personal property for investment tax credit purposes under pre-1981 case law, would also qualify as tangible personal property for MACRS. There are several factors used to determine whether an asset is an inherently permanent structural component or tangible personal property. Also, a new IRS legal memorandum provides guidance to taxpayers who have real property and who want to maximize depreciation deductions. This memorandum specifies that taxpayers must have "cost segregation studies" to support their depreciation position. There must be a "logical and objective measure" to support the estimate for "tangible personal property." Also, the legal memorandum states that a properly performed cost segregation study cannot be based upon "non-contemporaneous records, reconstructed data, or taxpayers estimates or assumptions that have no supporting records."

If a taxpayer desires to recharacterize the depreciation schedule of a real property asset that was previously placed in service, a change in method of accounting is required. Even if a taxpayer has not performed a cost segregation study on property that was purchased or constructed in the past, the IRS still allows the owner to have a cost segregation study done to restate the depreciation. Revenue Procedure 99-49, 1999-2 C.B. 725, outlines the requirements and processes required to obtain an automatic consent to change methods of accounting. This procedure describes the steps to retroactively change the method of accounting for depreciation. In general, any cumulative benefit obtained would offset taxable income ratably over a four-year period beginning with the year of change. Typically, a tax expert should be consulted on these changes in accounting methods.

Potential Benefits

Nearly every real property asset can benefit from a cost segregation study. Generally, the more specialized and unique an asset, the more benefits derived. More specifically, specialized assets, which may provide more significant tax benefits, include intense manufacturing facilities, highly concentrated retail projects and entertainment restaurants. More significant tax benefits are available for these assets. Also, the more detailed the costs and engineering analysis of a study, the more likely it is to maximize the tax benefits.

The potential tax savings can be estimated by calculating the "net present value tax benefit." To perform this calculation certain assumptions are made. These assumptions include the following:

* The weighted average cost of capital ("internal annual discount rate")

* The total capitalized cost of property placed in service

* The likely precost segregation property life classification

* An estimate of the combined state and federal tax rate

* A preliminary estimate of the postcost segregation property tax life classification.

The above factors can be used to estimate the current net present value tax benefits. Typically, the net present value tax benefit can range from 2 percent to 5 percent of the total capitalized cost of the asset. Illustrated in the following tables are examples of the cost allocation for pre-and post-cost segregation analysis for various property types. The net present value benefit calculation was based on a 40 percent combined federal and state tax rate and a 10 percent annual discount rate.

To summarize, sizable tax benefits are available to real estate owners and investors by utilizing cost segregation studies to accelerate tax depreciation. However, highly specialized, knowledgeable, experienced professionals are required to maximize and substantiate these tax benefits.

Pre-Cost Segregation Analysis

Property Type             Warehouse        Office

Bldg. & Site
Improvements             $15,000,000    $45,000,000
(assumed 39-year life)

Property Type            Manufacturing     Retail

Bldg. & Site
Improvements             $55,000,000    $17,000,000
(assumed 39-year life)
Post-Cost Segregation Analysis

       Section
     1245-5 Year          $900,000      $7,700,000

       Section
     1245-7 Year

       Section
     1250-15 Year        $3,000,000     $5,000,000

       Section
     1250-39 Year        $11,100,000    $3,230,000

    Present Value
       Benefit            $580,000      $2,400,000

     Net Present
    Value Benefit            3.8%           5.3%
     (percent of
     total cost)

       Section
     1245-5 Year          $525,000      $8,000,000

       Section
     1245-7 Year         $37,000,000

       Section
     1250-15 Year        $2,500,000      $200,000

       Section
     1250-39 Year        $14,975,000    $8,800,000

    Present Value
       Benefit           $8,300,000     $1,900,000

     Net Present
    Value Benefit           15.1%          11.2%
     (percent of
     total cost)

MATTHEW G. KIMMEL is partner-in-charge of Central Region Valuation Services in the Chicago office of Andersen LLP. He is also the U.S. team leader for cost segregation services. His e-mail address is matt.g.kimmel@us.arthurandersen.com

COPYRIGHT 2001 Tax Executives Institute, Inc.
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