Looming Tax Changes Amplify Cost Segregation Benefit for Real Estate

With growing expectations that Congress will soon pass legislation leading to a lower tax rate structure across the board, developers, buyers and owners of commercial real estate and residential rental properties should plan ahead to take advantage of the potential rate arbitrage opportunity that could accompany lower tax rates. Cost segregation studies are often overlooked by taxpayers because of the perception that they only result in a timing difference in how a building is depreciated. Savvy developers and owners of commercial properties know, however, that that significant tax deferrals, a boost in cash flow and an increase in capital immediately available for new projects make cost segregation more than a mere timing play.

In addition to these benefits, a reduction in tax rates would now open the door, for a “limited time” only, to a permanent tax saving. That tax saving can be explained by the fact that deductions applied at higher rates are more valuable today than in the future in the lower rate structure. Through cost segregation, taxpayers can reclassify personal property and land improvements now to the appropriate 5-, 7-, or 15-year recovery period, instead of leaving them in the longer 39-year recovery period associated with buildings (27.5-year for residential rental). This would enable taxpayers who placed into service a new building or a purchased real property in 2017 to maximize their depreciation deductions in 2017, and realize a permanent saving before decreased rates come into effect. This opportunity also applies to new or purchased properties placed into service in prior years for which a cost segregation study has yet to be performed.

What is cost segregation?

A cost segregation analysis is an engineering-based study of all the costs associated with the construction or purchase of a commercial real estate property or a residential rental property. The objective of the analysis is to allocate the costs resulting from the construction of a new real estate property, or from the purchase of an existing one, to either real property or personal property. In general, a real estate property includes elements of personal property that can be depreciated more rapidly than the elements of the property that relate instead to the structure and various systems required to operate or maintain a building.

As a result, instead of depreciating the entire real estate property over 39 or 27.5 years with a straight-line method, personal property assets identified during the course of cost segregation analysis are assigned shorter cost-recovery periods of five or seven years and can be depreciated using accelerated methods. Costs inherent to certain land improvements can be assigned to a 15-year recovery period. Therefore, a cost segregation analysis leads to faster depreciation write-offs that can translate into significant tax benefits for a taxpayer who owns commercial real estate.

Cost segregation can benefit any business or individual who owns commercial real estate or certain types of residential real estate. A cost segregation analysis can be conducted on any type of commercial real estate property, including multi-family properties, retail and shopping plazas, offices, manufacturing plants, mixeduse, warehouses, restaurants, banks, dealerships, hotels and more.

The tax benefits of a cost segregation analysis will vary greatly depending on the type of property. In general, for every $1 million reallocated from a 39-year property to a 5-year property, the net present value over the life of the property is approximately $200,000. The increase in cash flow associated with the reallocation of $1 million is approximately $330,000 over the first five years of placing the property into service.

Future partial disposition

Cost segregation is also a valuable tool that can be used in future partial disposition of an asset, a concept still relatively new to most taxpayers.

Regulations issued by the IRS in 2014 regarding the treatment of costs related to the repair and improvement of tangible property increased the value of cost segregation analysis as a tax planning tool. These regulations provide that a taxpayer can elect the partial disposition of an asset and write-off the remaining adjusted-basis of the disposed asset. These regulations also define eight different systems within a building, in addition to the building structural components, that each constitute a unit of property (UOP):

1. Heating, ventilation and air conditioning (HVAC) system
2. Electrical system
3. Plumbing system
4. Gas distribution system
5. Escalators
6. Elevators
7. Fire protection and alarm
8. Security system

A UOP is now the reference point for capitalization and disposition decisions. Because a cost segregation study enables taxpayers to allocate costs between the different UOPs of a building, it can be the foundation needed to make decisions regarding capitalization and partial disposition of assets with consideration for repairs or improvement to elements within a building’s UOPs.

The replacement of an aging roof is a good example. Prior to the 2014 regulations, taxpayers replacing a building’s roof would continue to depreciate the removed roof until it is fully depreciated, even if it was no longer in place. Supported by a cost segregation study that methodically allocates a value to each real property asset, a taxpayer can make a partial disposition election and write off the remaining cost of the roof, yielding what can be a significant tax benefit.

Where to start?

Increased cash flow, potential permanent tax saving opportunity, and basis for future partial disposition – these benefits should be overlooked.

Developers, real estate investors and owners of commercial properties should start by reviewing if a cost segregation study was ever performed on their existing real estate portfolio. The best time for a cost segregation analysis is in the months following the property being placed into service, but look-back studies can be performed and can yield significant benefits, depending on the facts and circumstances.

The second step is to discuss cost segregation with your tax advisor. Cost segregation involves principles of both tax and engineering and is usually performed by firms who have expertise in both fields. A qualified tax professional with an engineering background can conduct a cost segregation engineering study to reclassify the assets so you can accelerate depreciation, defer tax and increase cash flow.