December 7, 2007

Use cost segregation to cut Uncle Sam’s bite

  • Developers can use the strategy to depreciate properties quicker and free up cash flow.
    Moss Adams


    The Puget Sound commercial real estate market continues to be in the upper echelons of top performing markets in the country. Increased interest from foreign and nationally based investors has only added to soaring values and fierce competition for available properties. Coupled with recent trends toward more conservative lending practices, investors and developers are increasingly looking for opportunities to increase cash flow.

    Using effective tax-savings strategies can be a powerful vehicle for freeing up cash flow, positively impacting rates of return on existing investments and unleashing financial opportunities for new projects. Cost segregation is one such strategy that has become widely accepted and used by many real estate owners in recent years.

    What is cost segregation?

    Cost segregation is simply a tax deferral strategy. It’s the practice of segregating the cost components of a facility into the proper asset classifications and recovery periods for federal and state income-tax purposes. The result is significantly shorter tax lives (five, seven and 15 years), rather than the standard 39 years for commercial and 27.5 years for residential properties.

    Depreciation deductions are effectively front-loaded into the early years of ownership, pushing income-tax liabilities out into the later years and thus significantly increasing current cash flows and allowing owners to take advantage of the time value of money.

    The financial impact from a cost segregation study would look something like this: a commercial real estate investment firm acquired a neighborhood shopping center for $10 million in the current year and is looking for ways to optimize depreciation deductions to save on taxes and increase cash flow. A cost segregation study is conducted for the facility, resulting in $2.3 million in depreciation deductions over the first five years of ownership. This is in comparison to $1.2 million in depreciation that would have been deducted over this same time period using the standard 39-year depreciation rate.

    The cost segregation study allows the owner to depreciate an additional $1.1 million over the same five-year period, a tax savings of $385,000. Considering the time value of money, the study provides the owner with a present-value savings of up to $300,000 over the life of this facility.

    But what if this company had purchased the property in a prior year, and had never conducted a cost segregation study? Fortunately, the tax law allows owners to “catch-up” on previously missed depreciation in the current tax period, often resulting in significant cash flow impacts in the current tax year. The process for truing-up these depreciation deductions is done through a change in accounting method, an administratively friendly process, allowing for changes to be made to properties placed into service since 1987, without the need for amending any prior tax returns.

    Why doesn’t everyone do it?

    Most properties held for business use are eligible for cost segregation, however there are some key factors to consider when determining if cost segregation is a viable option for you or your company, including the type and size of property, the owner’s tax situation, holding period, passive activity rules and like-kind exchanges, among others.

    Who performs the studies?

    Cost segregation involves the application and understanding of tax law and the construction and engineering expertise to properly carve out and value the short-life components of a facility. This is why the IRS mandates that studies be conducted by professionals with expertise across all of these disciplines.

    A cost segregation team should include professionals with backgrounds in tax, engineering, valuation and construction. Cost segregation providers work closely with the owner’s tax accountants to ensure results are properly implemented and benefits fully realized.

    Cost segregation continues to be one of the most valuable and compelling tax strategies for commercial real estate developers and owners to free up much needed cash flow and enhance investment returns.

    Rob Grannum is a licensed CPA at Moss Adams and is the director of the firm’s cost segregation services practice. He leads a team of tax and construction professionals providing cost segregation studies for clients across a number of industries.

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