Cost segregation

Money doesn’t grow on trees, but a
cost-segregation analysis can help you
find it hidden behind the walls.

by David Zaslow and Ralph J. Consola   What would you say if someone offered you a dollar in exchange for a dime? Sounds too good to be true–we know. But what if your accountant said he had a service that would return $1 in tax savings for every ten cents you spent on the service? Most people would say, "Sign me up!" The service is called cost segregation, and it brings great IRS-recognized tax savings to building owners interested in retaining cash.

Getting personal speeds up depreciation

Building owners and their accountants generally understand that carpeting and cabinets may be identified as personal property for federal income tax purposes to obtain the increased tax deduction associated with shorter depreciable lives. Typically, these personal-property items total less than 3% of a building’s component costs. Meanwhile, the remainder of the facility is assigned a depreciable life of 39.5 years (27.5 years for multifamily facilities). A cost-segregation analysis maximizes a building’s tax benefits by identifying, classifying, and segregating more of a building’s assets as personal property for accelerated depreciation. This means three, five, sometimes 20 times more savings than can be obtained using only cabinets and carpeting.

Is there more than one power outlet in your office? How many linear feet of interior walls do not penetrate the suspended ceiling tiles? Is the decorative paneling in your reception area and conference room glued, nailed, or hung on the wall? Is there dedicated or increased cooling provided to accommodate data processing? These are just a few of the items that a cost-segregation specialist may identify to improve the cash position of building owners.

Plans and cost documents boost savings

Cost-segregation specialists perform a nonintrusive yet detailed engineering study of a building’s walls, flooring and ceiling, plumbing, electrical, lighting, telecommunications, heating, and cooling systems. For maximum benefit, cost-segregation professionals prefer to work from building plans and cost documents rather than relying on a building tour. Having the plans makes the facility walkthrough less labor intensive and is a better way to identify the maximum number of building components that can be placed into short-term depreciable categories.

Good documentation means less reliance on national cost manuals, which typically list items at lower than actual costs. Having both plans and cost documents means a better fee for service, since the cost-segregation professionals won’t need to spend as much time on the assignment. It also usually translates into higher savings for the client.

The assets are grouped under several asset-depreciation range classifications. The cost-segregation professionals then identify which components of each system that, according to federal tax law, can be assigned accelerated tax lives of five, seven, or 15 years rather than the straight-line 39.5 years (27.5 years for multi-family facilities). These resulting tax savings drop right down to your bottom line in the form of reductions of your tax liability.

The early bird gets the bigger deduction

Cost-segregation studies should be initiated as early in the construction or acquisition process as possible to obtain maximum savings. Consider these three points:

• If allowed 10 minutes with the architect before the design of a building begins, a cost-segregation professional can show the architect how to make a larger percentage of the building’s components qualify for short-term depreciation, thereby increasing the tax savings to the owner.
• Special-order building components such as granite counter tops on a reception desk, chandeliers, window coverings, etc., usually have a higher cost than can be obtained from national cost manuals. You must have proof of these costs in order to report the higher value to the IRS. If granted access to the construction chief before the project breaks ground, a cost-segregation specialist will request that five to 10 items’ costs be set aside for reporting. It is often more difficult to track down cost documents further along in the construction process.
• If a cost segregation study can be performed before the acquisition of a building, personal property can be separated from the building costs. The two costs can then be broken out in the sales agreement, and the real property transfer tax basis can be reduced.

The IRS demands that cost-segregation reports list the specifications of every component selected for accelerated depreciation. Cost-segregation analyses on properties where building plans and cost documents do not exist can therefore only be performed by someone with construction or engineering experience. This experience provides these specialists with the knowledge to determine the size, length, capacity, etc. of pipe, wiring, bracing, concrete, etc. located underground, in the walls, in the ceiling, and in the flooring without physically digging to get at them.

Recapture missed opportunities

Cost-segregation studies often produce results for properties that have been depreciating for as many as 10 years. Using the results from the cost- segregation analysis, your accountant can calculate what you should have paid in taxes had you depreciated the building using cost segregation, subtract what you already paid using straight-line depreciation, and come up with the amount overpaid. The IRS will return your overpayment in four equal payments over the next four years.

Once the cost-segregation study is complete, the results are effortlessly reorganized into two other useful reports:

1. Asset management. This is a fixed-asset and deferred-tax-liability report prepared to make life easy for your accountant.
2. Property tax. There are expenses in nearly every construction job that do not make the building more valuable: overtime incurred to get the building open on time, repair work, change orders due to plan changes, and replanting trees from their original place to another location on the lot. Such expenses should not be included in your property tax basis. Proper documentation from the builder will allow an accountant to track these costs for your use with the tax assessor.

A good cost-segregation study will not trigger an IRS audit. Having said that, make sure your provider can and will defend his position to the IRS for selecting each component for accelerated depreciation three to five years after the analysis has been performed. A good cost segregation analysis is based on well-founded interpretations of the Internal Revenue Code sections, applicable court cases, and revenue rulings.

David Zaslow, CPA, is a founding partner of RBZ, LLP. Founded in 1975, RBZ is a leading accounting and strategic business consulting firm with offices in Los Angeles and the Southbay. The firm offers a comprehensive range of accounting, tax, consulting, and litigation support services and serves a wide array of clients in diverse industries. He can be reached at 310/478-4148 or at dzaslow@rbz.com.

Ralph Consola is a vice president at Marshall & Stevens. Founded in 1932, Marshall & Stevens is a recognized leader in valuations and financial consulting serving clients around the world from nine U.S. offices and provides cost-segregation studies in affiliation with RBZ. He can be reached at 800/950-9588, ext. 327, and rconsola@marshall-stevens.com.

Photos © Comstock Images and PhotoDisc.

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