There's a hidden tax savings in your fixed assets

By KELLY MACDONALD
Moss Adams

The Puget Sound area is currently experiencing tremendous growth in the construction industry. Business owners are expanding manufacturing facilities, remodeling leasehold improvements and building new office structures. All too often businesses secure financing, finalize agreements and complete construction before consulting with their tax specialist.

Unfortunately, waiting until a project is completed to get help from a tax specialist may preclude the maximum potential tax savings from being realized. These same tax benefits can also be realized in property acquisitions and even in the event of death under certain circumstances.

Federal income taxes

Generally speaking, the Revenue Reconciliation Act of 1993 provides that the cost of buildings and structural components are depreciated over 39 years at an annual rate of 2.56 percent. However, many costs included in the building are actually considered tangible property that qualifies for accelerated depreciation over five or seven years.

A cost segregation study maximizes the after-tax cash flow by accelerating the depreciation deductions. Items that may qualify for a shorter federal depreciation life include:

• Primary and secondary electrical distribution systems where the electrical load is carried to equipment, telephone equipment, internal communications and computers
  
• Carpeting, vinyl floor coverings and accordion doors/partitions
  
• Signage
  
• Cabinetry, decorative millwork and removable vinyl wall coverings
  
• Decorative and security lighting

To understand the significance of the cost segregation analysis you must address the issue of structural components. Generally speaking, an asset is considered a structural component of a building if its removal would damage the building. For example, restroom partitions, structural plumbing and concrete block walls would be considered structural components because their removal would cause damage to the building.

Moveable partitions, decorative mill work, and seats in a baseball stadium would receive a more favorable depreciation treatment.

The structural component analysis does not always answer whether an asset can be depreciated more rapidly. As a result two additional tests: the function/use test and the inherent permanency test, assist in a final determination. Under the inherent permanence test, tax specialists look to answer these questions:

1. Is the property capable of being moved, and has it in fact been moved?
   
2. Is the property designed or constructed to remain permanently in place?
   
3. Are there circumstances which show that the property may or will have to be moved?
   
4. How substantial a job is removal of the property and how time-consuming is it?
   
5. How much damage will the property sustain upon its removal?
   
6. How is the property affixed to the land?

A second test is the function/use test. Under this test, assets used in a taxpayers trade or business that serve no functional purpose in the operation and maintenance of a building may depreciate more rapidly. For example, a HVAC system specifically used to meet the temperature or humidity requirements of computer system qualify for quicker depreciation.

In addition, some components of a building are attributable to both real property and personal property. For example, certain portions of the wiring and plumbing in a building are properly attributable to the general operation and function of a building. Simultaneously, other portions of wiring and plumbing perform functions specifically allocable to a particular piece of equipment and machinery.

Present value tax savings

The economic benefit derived from cost segregation studies often can be significant. The following chart illustrates potential savings for a moderately specialized industrial building. Actual results differ with the type of property.

Building owners should view the potential savings on a continuum, with high-tech manufacturing facilities realizing the largest tax savings and a simple warehouse reaping lesser amounts. There is also the tax benefit of requiring less interest to be capitalized during the construction period as a result of the cost segregation study.

Preparing a cost segregation report requires a thorough knowledge and understanding of case law, regulations and the IRS code. Therefore, it is important to enlist the help of an experienced cost segregation team. A typical cost segregation team includes individuals with experience in federal and multi-state tax, legal, engineering and construction.

These specialists will generally prepare a report which includes: 1) a narrative describing the work plan, authority, and methodology; 2) tax justifications to support each; 3) a comprehensive schedule of all cost allocations; and 4) a cost summary illustrating costs included in various class lives.

Other uses

The data and conclusions reached during a cost segregation study may also be used to disclose additional tax savings. A thorough understanding of the project as a whole and the individual costs allows the cost segregation specialist to leverage that knowledge into other areas. For example:

Manufacturing machinery and equipment sales tax exemption. Washington state provides sales tax relief to manufacturers when purchasing equipment.

Property tax affidavit. Certain costs incurred during construction do not add to the property's market value. Segregating these costs prior to the annual property tax reporting produces a permanent tax savings.

Cash flow benefits. The near-term tax savings provided by a cost segregation study gives taxpayers a boost to their cash flow in the years immediately following completion of their project. When the time value of money is considered, the study provides a significant economic benefit as well.

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