Fundamentals – Bonus Depreciation via Cost Segregation Studies with John Collins
Since Mr. Trump enacted new tax law, 100% Bonus Depreciation creates significant tax benefits in the acquisition year.
In one of my apartments $3M, 52-unit building is looking to get more than $266K in tax savings (at 37% tax rate) in his first year of ownership.
On syndications, depreciation is distributed to investors on the K-1 Form.
What is Cost Segregation?
Cost Segregation is the identification of building components and reclassifying the tax life on each of those components. Typical components that can be reclassified include a building’s non-structural elements, such as carpet, decorative lighting and trim, dedicated electrical and plumbing, and security systems; exterior land improvements, such as landscaping, curbs, sidewalks, fencing, and signage; and indirect construction costs, such as architect and engineering fees and construction permits.
Commercial properties establish a 39-year depreciation schedule, and residential properties establish a 27.5-year depreciation schedule. For example think of a 3 bedroom single family home in Birmingham, Alabama that is worth $100,000. Of that approximately $65,000 is determined to be the building value and $35,000 is determined to be the land value. Each year you can deduct 27.5th of the building value which is about $2,363 a year that can once again offset income gains. This can be taken for the next 27.5 years until all the value on paper is depleted. Unfortunately, you cannot deduct the land.
However, the IRS assigns a tax-life to each of the individual components.
Most components that qualify for accelerated depreciation can have their tax life reclassified to either 5, 7, or 15 years:
- 5-year tax-life components: tangible, personal property assets (carpeting, decorative lighting and trim, dedicated electrical and plumbing, and security systems)
- 7-year tax-life components: all telecommunication related systems (cabling, telephone, etc.)
- 15-year tax-life components: land improvements (landscaping, curbs, sidewalks, fencing, and signage)
What is a Cost Segregation Study?
A Cost Segregation Study is a strategic, tax-saving tool that can be used by companies and investors who have constructed, purchased, expanded, or remodeled any kind of commercial real estate (including 1 to 4 unit residential rental properties). The study allows the owner to take advantage of accelerated depreciation deductions and defer federal and state income taxes on the reclassified building components mentioned above.
During a Cost Segregation Study, components of a specific property or leasehold improvement are identified and reclassified for depreciation over a shorter time (5, 7, or 15 years). For example, 30% to 90% of the total electrical costs in most buildings can qualify for 5 or 7-year depreciation. The result of a Cost Segregation Study is that a property owner’s tax obligation is reduced and his cash flow is increased.
Is Cost Segregation something new?
Cost Segregation is not new. On the contrary, it has been in existence since 1954 when the IRS allowed for certain personal assets to be accelerated into a shorter life class. However, it wasn’t until Hospital Corporation of America sued the IRS in 1997, and won, that the IRS revisited the issue of accelerated depreciation. The IRS ruled that property qualifying as tangible personal property under the former Investment Tax Credit (ITC) rules would also qualify for purposes of federal income tax depreciation under MACRS (Modified Accelerated Cost Recovery System).
The IRS Chief Attorney wrote a memo saying, “. . . Cost Segregation, for it to be properly applied, had to involve those with competencies in architecture, engineering or construction and/or construction techniques, in order for personal property assets to be accurately identified and segregated.” As a result of this memo, Cost Segregation became a viable tax-saving strategy allowed by the IRS.
What type of real estate is eligible?
Commercial real estate (including 1 to 4 unit residential rental properties) eligible for Cost Segregation includes buildings that have been purchased, constructed, expanded, or remodeled since 1987. A study is typically cost-effective for buildings purchased or remodeled at a cost greater than $100,000. A Cost Segregation Study is most efficient for new buildings under construction, but it can also uncover retroactive tax deductions for much older buildings.
What are the steps involved in the process?
From start to finish, the Cost Segregation process can be broken down into the following steps:
- Engage a reputable Cost Segregation firm that utilizes engineers and architects trained in Cost Segregation and its application to the proper allocation of assets.
- The engineer determines what documents are available (e.g. planning, construction, invoices, appraisal, and current tax depreciation) for reference and referral.
- The engineer then sets a schedule for surveying the subject property and gathering the available documents for review prior to arrival at the subject property.
- For those documents that are unavailable, time is then scheduled into the Cost Segregation process for document recreation using known industry standard costing data (Marshall & Swift and/or RS Means costing publications). After all necessary documents are acquired, it takes about 4 to 6 weeks to finish the process.
- The site survey is executed and completed. Time varies for each survey, but it can be completed within as little as an hour. During the survey, measurements are taken and all areas are photographed for IRS verification and substantiation of asset values.
- The engineer returns to the office and “crunches the numbers.” This is when all documents are reviewed in detail, assets are verified and measured against known costing data, and asset reallocation is applied.
- A review committee then examines the results of the analysis completed by the engineer of record to verify its veracity and confirms it meets and exceeds IRS guidelines per the Cost Segregation Audit Techniques Guide.
- Once approved, the study results are compiled into a final report that includes: all IRS tax code to substantiate the reallocated assets, spreadsheets identifying all assets categorized according to their building codes, representative photographs of the reallocated assets, and the engineer’s credentials for IRS review.
- Final report is issued. Digital copies are emailed to the client and the CPA of record for application to the client’s tax return.
Why bother? I’ll eventually get the deduction.
As investors, we like paper depreciation to occur earlier because that offsets gains earlier and gets more money in our pocket earlier. Just like you give a mouse a cookie…. Give an investor a dollar early and… they will turn em and burn em.
In other words, you are not creating more depreciation but you are shifting it earlier to take advantage of the time value of money concept.
On the project level in a single asset LLC arrangement the more you can lower your tax liability the more you can significantly increase your cash flow and create more value for investors.
A Cost Segregation Study in effect gives you an interest-free loan from the government for the first 15 years, which you will then repay interest-free over the remaining 25 years. Wouldn’t you rather have your money? There are also advantages to doing a study if the building is going to be sold (via 1031 exchange) or if the owner of the building dies.
Does the Cost Seg need to get done this year (Dec 2018) or do we just need to acquire in this year (2018)?
For bonus depreciation, we just need to acquire. The Cost Seg can be completed in the next year (2019).
How much will I save on taxes?
Most Cost Segregation firms will perform a free analysis if you provide your basic property information and tax rate. From the information you provide, they can provide a conservative estimate of the accelerated benefits you can expect, as well as their fixed fee proposed for the final study.
Typically, tax savings from 5% to 10% of the building’s original tax-basis are generated, but there are instances where it can be substantially more. Each property and circumstance is unique, so it requires a case-by-case approach to give you a definitive answer.
How much-accelerated depreciation can I get?
Certain types of commercial property can be grouped together to give us an idea of the percentage of those types of buildings eligible for accelerated depreciation. Your results may be greater, or less than those quoted here, but in general, property that falls into one of the following categories is most likely to result in accelerated depreciation within the specified ranges.
Commercial Property Types:
- Apartment Buildings 15 – 25%
- Dental/Medical 30 – 60%
- Health Care 25 – 65%
- Heavy Manufacturing 30 – 80%
- Industrial 25 – 70%
- Light Manufacturing 20 – 45%
- Office Buildings 15 – 25%
- Research & Development Facilities 30 – 75%
- Restaurant 15 – 30%
- Retail Centers 10 – 25%
- Senior Living Facilities 15 – 30%
- Warehouse 5 – 15%
Does Cost Segregation have other benefits?
Yes. Cost Segregation can provide additional tax benefits. It can reveal opportunities to reduce real estate tax liabilities and identify certain sales and use tax savings opportunities. Under certain circumstances, segregated assets may qualify for a special bonus depreciation allowed by multiple tax reconciliation acts enacted by Congress. Additionally, a Cost Segregation Study can
- Maximize tax savings by adjusting the timing of deductions. When an asset’s life is shortened, depreciation expense is accelerated and tax payments are decreased during the early stages of a property’s life. This, in turn, releases cash for investment opportunities or current operating needs.
- Create an audit trail. Improper documentation of cost and asset classifications can lead to an unfavorable audit adjustment. A properly documented Cost Segregation Study helps resolve IRS inquiries at the earliest stages.
- Capture retroactive savings. Since 1996, taxpayers can capture immediate retroactive savings on property added since 1987. Previous rules, which provided a four-year catch-up period for retroactive savings, have been amended to allow taxpayers to take the entire amount of the adjustment in the year the Cost Segregation is completed . . . this alone is huge. This opportunity to recapture unrecognized depreciation in one year presents an opportunity to perform retroactive Cost Segregation analyses on older properties to increase cash flow in the current year.
- Lower property insurance premiums. Since it generally costs less to insure personal property, versus real property, building components reallocated as personal property should reduce your insurance costs as well.
How much does a Cost Segregation Study cost?
On average, the total fee will generally fall between 5% and 20% of the estimated Net Present Value tax savings shown on your free analysis. This can be impacted by how large or small the real estate project is. In addition, the location, accessibility, and quality of the records and documents impact the ultimate cost. Minimum fees can be as low as $2,000 for small projects, and some firms GUARANTEE a minimum of 500% ROI (fee vs. tax recovery) on projects over $500,000.
How long does a Cost Segregation Study take?
The time that a Cost Segregation Study takes depends on the size of the project and the completeness of the documentation that you can supply. Generally, it takes about 4 to 6 weeks from the time the appropriate documentation is received and recreated.
What is required of me to have a study done?
You need to provide as much of the original documentation pertaining to planning, construction, and current tax depreciation as you can. This could include a complete set of construction plans, current tax depreciation records such as tax returns, building cost budget information, final AIA (American Institute of Architects) application and a document of certification for payment or other cost information, change orders, direct or indirect costs paid by the owner that are not included in other documents, and other information depending upon the project.
What if I lack some of the needed documents?
Even if you lack some of the necessary documentation, a study can still be performed for you. Construction, engineering, and other specialists will do an extensive site visit. They will measure and estimate using currently accepted costing techniques and pricing guides (such as the IRS-recommended costing publications Marshall & Swift and RS Means) to determine the costs that qualify for shorter recovery life periods.
Can’t my CPA do a study for me?
CPAs are not qualified according to the IRS guidelines. However, most Cost Segregation firms will gladly work with them on a consulting basis to complete the work for you. Remember, the IRS Chief Counsel issued a memo that made it clear what constitutes proper “methodology” in applying Cost Segregation, and it must be done by people who are competent in architecture, engineering or construction and/or construction techniques. See “Is Cost Segregation something new?” above.
Will a study increase the chance of an audit?
A study conducted by a reputable Cost Segregation firm should strictly adhere to the IRS Cost Segregation Audit Techniques Guide. The type of study most firms perform actually decrease your chances of an audit because the study places you in Internal Revenue Code Tax Compliance. However, be aware there are six different Cost Segregation methods allowed by the IRS, and not all are of equal merit. There is currently no standard method, and there is still some ambiguity about which method is best. If you have heard conflicting information about what is, and is not possible regarding Cost Segregation, this is probably why – it depends on which method is being used.
Will I be assisted in the event of an audit?
A reputable Cost Segregation firm can assist you in the event of an audit. They will focus on doing the Cost Segregation Study to create documentation and support for conclusions so that these are easily communicated and resolved with the IRS. In fact, you should expect a final report that is “all inclusive.” It should quote specific Internal Revenue Codes related to the reallocated assets. Additionally, it should provide photographic evidence of these same assets for complete substantiation of the assessment.
- Reduction in tax liability
- The deferral of taxes
- Bump in up front cash flow
- Costs typically range $4,000-$8,000, depending on property size/asset value
- Accurate and complete documentation is required and requires effort to collect
- Cost segregation is not feasible below $100,000 property value
Cost Segregation studies is one of the easiest and quickest way to squeeze a little extra profit out of an investment. If you played race video games in your youth (or still do) it’s like paying for the inexpensive computer chip upgrade, its a no brainer. If you don’t get that reference, its “low hanging fruit.”
If this is a concept new to you, you may be able to go back to previous years taxes and get back some benefits this year. Often times getting a quote is free and quick.
A recent quote I got back for a few properties.
Who do I call for more information?
For more information on Cost Segregation or a free analysis, contact John Collins, Cost Segregation Specialist at Segregation Holding LLC: (907) 227-2440 or email@example.com.
Segregation Holding LLC performs Cost Segregation Studies in all 50 states and throughout the globe for US tax-paying citizens owning investment property outside the US.
Dental Smile Example
Ranch resort Example
Combine this with an Opportunity Fun Zone deal and wow!
Ep. 14 – Nate Busch of Busch Tax Company – Podcast download here
Sample K1 Form