COST SEGREGATION CAN PROVIDE REAL ESTATE purchasers with tremendous tax benefits from accelerated depreciation deductions and easier write-offs when an asset becomes obsolete, broken or destroyed.

CPAs CAN RECOMMEND USING THE cost segregation technique when a taxpayer constructs a building or buys an existing one. It can be used even if a structure was acquired several years earlier.

WE WROTE THE BOOK ON COST SEGREGATION:  The Practical Guide to Cost Segregation Chapter 7 (pdf)

BUYERS OF REAL ESTATE SHOULD OBTAIN an engineering report that segregates assets into four categories: personal property, land improvements, building components and land.

ONE OF THE AREAS OF CONTROVERSY is the distinction between tangible personal property and a building’s structural components. The Tax Court has set forth criteria CPAs can use in making a factual determination of whether property is inherently permanent and therefore excluded from the definition of tangible personal property.

ADVANTAGES OF COST SEGREGATION include the value of front-loaded depreciation deductions, write-offs of building components that need replacement and lower local realty-transfer taxes.

Purchasers of real estate can gain tremendous tax benefits by using a popular asset depreciation technique called cost segregation. Using this method, buyers view a real estate acquisition as consisting not only of land and buildings but also tangible personal property and land improvements. The tax savings come from accelerated depreciation deductions and possible easier property write-offs. A taxpayer can use cost segregation when constructing a building, buying an existing one, or, in certain circumstances, years after disposing of one so long as the year of disposition is still open under the statute of limitations (see revenue procedure 2004-11).

CPAs play a central role in the cost segregation process. They are the most likely people to recommend use of the technique to their clients or employers. CPAs also will review and implement the findings in the required engineering report. We will guide you through the process by discussing how cost segregation operates, providing a comprehensive example of the technique in a real estate acquisition and outlining its advantages and disadvantages.

A BRIEF HISTORY
Under prior law taxpayers would separate a building’s parts into its various components—doors, walls and floors. Once these components were isolated, taxpayers would depreciate them using a short cost-recovery period. CPAs referred to this practice as component depreciation.

The introduction of the accelerated cost recovery system (ACRS) and the modified accelerated cost recovery system (MACRS) eliminated the use of component depreciation, but not the use of cost segregation. Hospital Corporation of America [HCA] v. Commissioner, 109 TC 21 (1997), is the seminal cost segregation case. In it the Tax Court permitted HCA to use cost segregation with respect to a multitude of improvements (see exhibit 1). Critical to the Tax Court’s analysis was that in formulating accelerated depreciation methods, Congress intended to distinguish between components that constitute IRC section 1250 class property (real property) and property items that constitute section 1245 class property (tangible personal property). This distinction opened the doors to cost segregation.

Armed with this victory, taxpayers have increasingly begun to use cost segregation to their advantage. The IRS reluctantly agreed that cost segregation does not constitute component depreciation (action on decision (AOD) 1999-008). Moreover, cost segregation recently was featured in temporary regulations issued by the Treasury Department (regulations section 1.446-1T). In a chief counsel advisory (CCA), however, the IRS warned taxpayers that an “accurate cost segregation study may not be based on noncontemporaneous records, reconstructed data or taxpayers’ estimates or assumptions that have no supporting records” (CCA 199921045).

HOW THE TECHNIQUE WORKS
The process of cost segregation begins at the time of purchase. Accounting professionals should advise clients or employers buying real estate to use an engineering report to segregate assets into four categories:

Personal property. Taxpayers normally can depreciate this property over a five- or seven-year recovery period and the double-declining balance method. Within permissible bounds, there is a huge tax-savings premium for valuing this property as high as possible. This category includes items such as furniture, carpeting, certain fixtures and window treatments.

Land improvements. Like the first category, these have a relatively short useful life—15 years—and are subject the 150% declining-balance method. Again, within permissible bounds, purchasers should maximize the values they attribute to this category, which ordinarily includes items such as sidewalks, fences and docks.

The building. As in the first and second categories, buyers should attempt to maximize a building’s value as opposed to non-depreciable land.

Land.  Land is generally allocated proportionately with the building to the approved or assessed value, or by some other reasonable means.

This allows a purchaser to achieve faster depreciation deductions as well as possible and easier subsequent write-offs, so its cash flow will be increased. Assets allocated into the first two categories enjoy relatively short useful lives and, thus, accelerated depreciation methods. Furthermore, if the components of a building have been separately valued and a component subsequently becomes worthless, the taxpayer can write it off more easily.

COST SEGREGATION EXAMPLE
A thorough analysis of the facts of each situation helps CPAs quantify the present -value tax savings associated with using cost segregation.

Consider the following example based on an actual cost segregation engineering report. Suppose a taxpayer purchases a nonresidential building for $12,135,000 (assume the land is already segregated). If the taxpayer does not use cost segregation, it must use straight-line depreciation over 39 years. In contrast, suppose the accounting professional advises his or her client or employer to retain a professional  to prepare a cost segregation study. The engineer’s report shows that of the total purchase price, $11,285,000 should be allocated to the building, $50,000 to 15-year property and $800,000 to 5-year property. Allocating part of the purchase price to these two additional property categories results in tremendous tax savings. Assuming a 35% tax rate and a 7% discount rate, the cost segregation study produces $142,417 of tax savings.

WHEN TO APPLY THE TECHNIQUE
CPAs should keep three additional things in mind. First, the 2001 and 2003 tax acts made cost segregation more valuable. If real property is reclassified as 5-, 7- and 15-year personal property, it may qualify for 30% and 50% bonus depreciation. This bonus depreciation applies to new property in the first year it is placed in service. The magnitude of this additional allowance in the first year can be enormous. For example, a shift of $1 million from 39-year property to 5-year property can augment first-year depreciation deductions by a whopping $575,000 ($25,000 vs. $600,000). The resulting increase in cash flow can provide the capital for numerous other projects.

Second, cost segregation is applicable not only when taxpayers acquire new or existing structures but also when they previously had acquired or improved a structure and have the proper engineering report to justify cost segregation. (If, however, the real property in question was put into service too many years ago— commonly 10—there may be insufficient adjusted basis remaining to justify using cost segregation.)

Third, regulations issued in March 2004 sanction the use of cost segregation years after a real estate acquisition. Treasury regulations section 1.446-1T(e)(5)(iii), example 9, poses a situation where a cost segregation study was conducted four years after an initial building acquisition; the study showed the taxpayer had missed opportunities to take enhanced depreciation deductions. Under these circumstances the taxpayer was permitted to make an IRC section 481 adjustment all in the year it changed its method of depreciation. These changes in methodology, however, require that the taxpayer in a timely manner file form 3115 for permission to change its depreciation accounting method, which is granted automatically under current revenue procedures.

Today virtually all real-property purchases entail the simultaneous acquisition of tangible personal property. For that reason CPAs should routinely recommend the use of cost segregation studies whenever the expenditures for an acquisition, including leasehold improvements, equal or exceed $750,000.