Home
Guest Articles
Real Estate Owners Enjoy Cash Flow And Tax Savings from IRS Windfall
by
Grant Keppel, CPA
Freed Maxick Group
For
companies that have purchased, constructed or substantially renovated a building
since 1987, a recently released Revenue Procedure, coupled with a landmark Tax
Court case, provide new impetus to undergo a Cost Segregation Study that could
result in significant and immediate cash flow and tax savings.
While
the enactment of the Tax Reform Act of 1986 eliminated the Investment Tax Credit
(ITC), it substantially altered the depreciation system for real and personal
property by classifying assets into nearly 130 different categories, each with
its own depreciable life. This
pattern of depreciable lives is known as the Modified Accelerated Cost Recovery
System (MACRS).
In the landmark Tax Court
case Hospital Corporation of America, 109 TC 21 (1997), the court held that if
the property would have qualified as tangible personal property under the
repealed ITC, that same property would also qualify as tangible personal
property under MACRS. In addition, a 1998 IRS Revenue Procedure allows real
estate owners to automatically go back to closed tax years and
"catch up" the entire omitted depreciation, without amending tax
returns.
A Cost Segregation Study will identify and price non-structural elements and
exterior improvements, making it possible for property owners to maximize their
depreciation deductions by reclassifying as much as possible of the related
costs from building costs to personal property and exterior improvements. In
addition, indirect construction costs such as construction period interest,
general conditions, architecture and engineering fees are allocated on a
pro-rata basis to the assets identified as non-structural. By maximizing their
depreciation deductions, building owners increase their cash flow by paying less
income tax during the early years of a building's depreciable life.
As stated earlier, the owner is also eligible to play
"catch-up" for depreciation errors made in prior years.
Under today’s guidelines, a commercial building is depreciated for tax
purposes over 39 years (27-1/2 years for residential real estate). Upon
segregation of tangible personal property and exterior improvements from a
building’s cost, companies realize the benefits of deducting accelerated
depreciation on assets otherwise lumped together with a building’s cost.
Depending on the type of industry, 20-50% of building costs can be segregated
into 5, 7, or 15-year lives instead of a 39-year life.
Examples of tangible personal property include process heating and ventilating
systems; wall coverings; electrical and plumbing costs that relate directly to
the processing equipment; flooring; movable wall partitions and appliances.
Examples of exterior improvements include sidewalks, drainage, parking lots,
landscaping, roads, site utilities, fencing and outdoor lighting.
The savings from an accelerated recovery can be quite significant.
Take the example of a heavy manufacturer who purchased a new facility in
1992 for $5 million, $1 million of which was for equipment costs. The company had been depreciating the building cost of $4
million over 31-1/2 years, and the $1 million of equipment over seven years.
A cost segregation study was performed, segregating 15 percent of the
building cost to fifteen-year property and 15 percent to seven-year property.
As a result of the segregation, the total taxes deferred over a four-year
period exceeded $300,000, while the cumulative present value on the taxes
deferred at eight percent was approximately $175,000 (assuming a combined
federal and state effective tax rate of 48 percent).
Real estate investments best suited to undergo a cost segregation study include all
post-1986 real estate construction, building acquisitions or improvements; new
buildings under construction; the purchase of existing property; existing
buildings undergoing renovation or expansion; and office leasehold improvements
and "fit outs."
Other factors to be considered when deciding to undergo a cost segregation study
include profitability of the entity or its shareholders, passive activity rules,
early disposition, and other tax-related situations.
For additional information regarding cost segregation studies and their effect
on your business, contact Grant Keppel, National Director of Cost Segregation
Services at (800) 777-4885 or email gkeppel@freedmaxick.com