Benefits of Cost Segregation in Real Estate���

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Presented By: Todd Wohl Partner

Braun Co www.Braunco.com

Cost Segregation •  Term Defined

!  Accurate distribution of acquisition or construction costs into real and personal property

!  Method of segregating direct and indirect costs for tangible property and land improvements from building and building improvements

Cost Segregation •  When should you consider performing a Cost

Segregation Study?

–  Purchase of real property –  Completion of significant tenant improvements –  Estate property transfer intra-family (i.e. - it may still

be owned by the same family, but a new basis has been set by the transfer)

•  While the above represent ideal circumstances, owners of real property can frequently benefit years (as many as 8 after date of purchase depending on circumstance) after any of the above events have taken place.

Cost Segregation Example •  Owner Todd purchases a property for manufacturing

purposes in October 2003. Amount allocated to the building is $1,900,000.

•  Since the building is commercial property, Todd would depreciate it evenly over a period of 39 years, resulting in an expense of $10,165 in the first year, $48,716 for the next 38 years and finally $38,627 in the last year

•  However, by performing a cost segregation study, Todd is able to reclassify 11% of the building as 5 year personal property, 6% as 7 year personal property and 14% as 15 year personal property.

Cost Segregation Example (Results) •  Todd can now depreciate portions of the building at an

accelerated rate over 5, 7, and 15 years as opposed to 39 years.

•  The result is Todd can write off in the first year of ownership $310,436 as opposed to $10,165. This translates into a tax savings of $120,109, assuming an effective tax rate of 40%.

•  Finally, because Todd performed a cost segregation study and reclassified 31% of his building as personal property, his real property taxes will also be reduced since these taxes are based on the value of the real property at the time of purchase.

Background 1.  Cost Segregation was initiated to help taxpayers

maximize benefits by claiming investment tax credits (ITC)

2.  ITC was only permitted on personal property

3.  The same engineering analysis used in ITC studies is now used to maximize depreciation deductions that increase cash flow through tax savings.

Recent Timeline 1981 - Economic Recovery Tax Act (ERTA) established

depreciation recovery periods for most business assets at 5 to 15 years

1984 - Deficit Reduction Act (DRA) lengthened recovery periods to

19 years for real estate 1986 - Tax Reform Act of 1986 eliminated building components

depreciation (plumbing, HVAC, etc.) and established Modified Accelerated Cost Recovery System (MACRS)

MACRS

Account Classification Tax Depreciation Life (years)

Tax Depreciation Method

Building • Industrial/Commercial • Apartment

31.5 27.5

Straight Line

Land Improvement 15 150% Declining Balance

Personal Property 5 and 7 Double Declining Balance

Timeline (cont.) Tax Acts Since 1986

1993 - Revenue Reconciliation Act (RRA) lengthened non-residential recovery period to 39 years

2002 - Job Creation and Worker Assistance Act (JCWAA) provided

for 30% bonus depreciation on assets with a recovery period of 20 years or less

2003 - Jobs and Growth Tax Relief Reconciliation Act (JGTRRA)

increased the bonus rate to 50% on qualifying assets

Tax Court Cases 1.  Hospital Corporation of America (1997) – clear evidence

by Court of tangible personal property vs. structural components (same rules as old Investment Tax Credit)

2.  L.L. Bean (1998) – Court reaffirmed Whiteco Industries (1975) standards for inherent permanency test

3.  H.E. Butt Grocery (2002) – reinforced claim for added depreciation based upon expert cost segregation study

IRS Legal Memorandum 199921045 1.  Validated and acquiesced to the Court’s conclusion

in Hospital Corporation of America (1997)

2.  Stated necessity for cost segregation studies to be performed by professional engineers or architects

Revenue Procedures 1.  Rev. Proc. 99-49

a.  Taxpayer requests automatic change of accounting method to claim prior years depreciation not taken or taken at lesser amount

b.  No need to file amended tax return

2.  Rev. Proc. 2002-9 (as modified by Rev. Proc. 2002-19) a.  Requires supporting evidence for Form 3115, Application for

Change in Accounting Method b.  Allows all underreported depreciation to be taken in one year

(current or future year)

Change in Accounting Method Courts divided on whether changing the lives for depreciable assets under MACRS is a change of accounting method that requires the filing of Form 3115

a.  The 5th Circuit in Brookshire Brothers Holding Company (2003) disagreed with the IRS on this issue and indicated it was not a change

b.  The 8th Circuit in O’Shaughnessy v. Commissioner (2003) agrees with the 5th Circuit

c.  The 10th Circuit considered this issue in Kurzet, Stanley M. v. Commissioner (2000) and sided with the IRS

Potential Complexities 1.  Not a REIT

2.  1031 like-kind exchange: requires cost segregation study of both properties

3.  Operating or passive loss carryovers may defer the cost segregation benefits

Potential Complexities (cont.) 4.  Leasehold improvements

a.  Who owns and depreciates b.  Separate from building

5.  Alternative Minimum Tax (AMT): may limit use of maximum depreciation

6.  Retention of property for more than a few years

Projects to Consider 1.  Post 1986 construction or acquisition

2.  Renovation, remodeling, restoration or expansion

3.  Minimum $1 million in depreciation improvements

Preview the Benefits Provide the data for each buy/build:

1.  Type property (e.g. shopping center) 2.  Year purchased/built and purchase cost (contractors’ cost

breakdown for new construction) 3.  Square footage 4.  Tenant rent roll(s) 5.  Description of personal property 6.  Available drawings – full, partial or none

Other Benefits 1.  Reduced property tax

a.  Real property 1)  Tax values increase up to 2% per year 2)  Less cost basis

b.  Personal – value depreciates per life category 2.  Proper values for insurance

a.  Correct categories b.  Estimate current replacement cost c.  Facilitates proof of loss

3.  Property/Asset Ledger a.  Track asset changes (e.g. retirement) b.  Allocation proper for 1031 exchange c.  Basis for recapture calculations

Separate Land from Building and Improvements

1.  Primarily relates to acquired real estate

2.  Four methods for determining value a.  Assessor’s allocation b.  Full property appraisal c.  Land only appraisal d.  Arbitrary allocation by taxpayer

3.  The purpose of this is to push the land value down and increase the basis for depreciation. Generally speaking, the most audit-resistant method for doing this is a land only appraisal.

Cost Segregation Elements 1.  Comply with strict IRS requirements

a.  Detailed analysis and report b.  Supportable basis for allocation of directs and indirects

2.  Understand tax law a.  Prior experience negotiating with IRS b.  Assertive application, but not excessive

3.  Construction/engineering expertise a.  Thorough knowledge base b.  Understanding of unique property c.  Complete buildup of cost detail for each property unit

4.  Expert a.  Respect from IRS b.  Testimony in Tax Court

Two Primary Tests 1.  Function/use – asset serve any purpose in building operation 2.  Inherent permanency – asset easily removed without significant

damage to structure, based on: a.  Is the property capable of being moved, and has it in fact been moved?

b.  Is the property designed or constructed to remain permanently in place? c.  Are there circumstances that tend to show the expected or intended length

of affixation? d.  How substantial a job is the removal of the property, and how time

consuming is it? e.  How much damage will the property sustain upon removal of the

property? f.  What is the manner of affixation of the property to the land?

Cost Segregation Process 1.  Discuss with client the uses of various types of equipment and structures 2.  Examine in detail the construction drawings and specifications to determine the

nature of land improvements, facility construction and facility service systems 3.  Conduct on-site inspection of the facility and take photographs 4.  Prepare an itemized identification of property units that qualify for 5, 7, 15 or

39 year lives (27.5 for apartments) 5.  Redistribute cost data into meaningful categories to balance & reconcile take-

off cost estimates and cost entries with actual cost (as available) 6.  Analyze all cost data, including contractor applications for payment, change

orders and indirect costs 7.  Distribute actual direct costs to qualified property units, based on an

engineering quantity survey of the facility by contract 8.  Once the estimated and actual costs are balanced, the cost segregation program

allocates contract indirects and project indirects and re-sorts them into the appropriate property units

Examples – 15 Year Property 1.  Sidewalk 2.  Road 3.  Waterway 4.  Sewer 5.  Wharf and dock 6.  Fencing 7.  Landscaping 8.  Shrubbery 9.  Parking lot 10.  Light pole base 11.  TV/radio transmitting tower 12.  Electric utilities

Examples – 7 Year Property 1.  Office – furniture, fixtures and some equipment 2.  Security life 3.  Signage 4.  Cabinetry 5.  Decorative lighting 6.  Window washing equipment 7.  Security system 8.  Fire extinguisher 9.  Carpeting 10.  Awning 11.  Window covering 12.  Demountable partition

Examples – 5 Year Property 1.  Studio sound 2.  Computer system 3.  Equipment electrical 4.  Special flooring/footing 5.  HVAC for equipment 6.  Cleaning system 7.  Waste treatment/exhaust system 8.  Special lighting 9.  Specialized equipment 10.  Equipment air line 11.  Mechanical connection 12.  Cooler and drain line

Typical Percentages of Accelerated Property Property % Reclassified Apartment 5-15 Car Dealership 25-45 Data Center 25-30 Department Store 5-15 Distribution Center 10-15 Fast Food Restaurant (Class 57 – 5 years) 40-50

Golf Course 20-25 Grocery Store 20-30 Hospital (for profit) 30-35 Hotel/Casino (Class 57 – 5 years) 20-30

Hotels 15-20 Malls 8-30

Property % Reclassified Manufacturing (Heavy) 30-50 Manufacturing (Light) 15-20 Medical Clinic 20-30 Medical Office 10-15 Office Building 8-12 Pharmaceutical Mfg. 50-55 R&D Facility 20-40 Restaurant 20-40 Retail 25-35 Semi-conductor Mfg. 35-40 Supermarket 30-35 Theatres 20-30 Warehouse 8-10

Braun Appraisal Services ���Cost Segregation Division

•  National reach •  Standards

! USPAP & ethics certified !  Recognized by Federal Tax courts and IRS ! American Society of Appraisers - most senior

appraiser designation ASA ! Appraisal Institute - MAI !  State Licensed - CGREA

•  Expert testimony