Understanding the legal background and rationale for property taxpayer cost allocation is crucial for comprehending cost segregation studies and their intricacies. Based on the IRS Cost Segregation Audit Technique Guide, O’Connor will educate you about asset clarity, depreciation changes, and how it can get you ready for a cost segregation investigation.

Accelerated Cost Recovery System: 1981

In 1981, Congress put into place the Accelerated Cost Recovery System (ACRS) – a cost recovery method – to simplify depreciation rules to allow greater deductions over shorter periods of time. By adding a statutory percentage to the cost of the recovery property, ACRS permitted depreciation deductions over a defined recovery period. A statutory percentage or tax rate is the rate mandated by law on taxable income that falls within a given tax bracket. With the introduction of ACRS came many changes, for example the removal of salvage value and the concept of useful life. Under ACRS, cost recovery of assets was faster and provided a total of six recovery periods. Between 1981 and 1886 many properties during this time were eligible for ACRS. Other changes that came from ACRS was preventing component depreciation as a method for calculating depreciation for buildings.

According to ACRS, starting on the later of the date the building is brought into service or the component is placed into service, the depreciation deduction for any building component must be calculated in the same way as the deduction permitted for the structure. This new system brought along several changes to depreciation; however, it was beneficial for many taxpayers since it allowed for greater deductions overall.

Modified Accelerated Cost Recovery System: 1986

In 1986, ACRS was modified by congress and was later renamed Modified Accelerated Cost Recovery System (MACRS). With the modification came new changes and improvements to the system. For example, MACRS repealed ACRS § 168(f)(1), which related specifically to components of § 1250 class property. MACRS was a cost recovery method that was based on the applicable depreciation method, recovery period, and convention outlined in § 168.

The applicable depreciation method is the most straightforward and reliable approach for calculating depreciation, because it makes sense when working with an item whose value declines consistently over time at the same pace.

With the modification of ACRS, MACRS provided two depreciation systems:

1. General Depreciation System (GDS) – a method used to compute personal property’s depreciation. GDS allowed for the use of tax depreciation known as the declining – balance – method.

2. Alternative Depreciation System (ADS) – a method of calculating the depreciation of certain types of assets in certain conditions. The ADS technique lowers the annual depreciation expenditure reported by using the straight-line approach to compute depreciation over a longer time period than the GDS method.

In order to calculate depreciation deductions for later years, MACRS also needed the necessary basis modifications. Additionally, it amended other ACRS regulations, such as property classifications. For structures and structural elements, the recovery time increased significantly under MACRS. The applicable depreciation method, convention, and recovery time were impacted by the property’s MACRS classification in addition to the new depreciation methods. Each item of property depreciated under MACRS is assigned to a property class. Class lives for MACRS are outlined in Rev. Proc. 87-56, 1987-2 C. B. 674. A property class establishes the item’s recovery period. Statutes or class lives are used to calculate the applicable recovery periods for MACRS.

Rev. Proc. 87-56, 1987-2 C. B. 674 established two broad categories of depreciable assets:

1. Asset classes 00.11 through 00.4 consist of specific assets used in all business activities.

2. Asset classes 01.1 through 80.0 consist of assets used in specific business activities.

By the end of 1986, MACRS continued preventing component depreciation as a method for calculating depreciation for buildings. MACRS enacted § 168(i)(6), improvements made to real property are depreciated using the same recovery period applicable to the underlying property, assuming the underlying property was placed in service at the same time the improvements were made. Improvements to § 1245 property and §1250 property. In the next blog, O’Connor will discuss the terms “§ 1245 property” and “§1250 property” and the meanings given by §1245(a)(3) and §1250(c).

Since the early 1930’s, depreciation regulations have encountered many modifications and changes so as to benefit taxpayers. Depreciation helps taxpayers increase cash flow by reducing reportable income. A good cost segregation study is an excellent tool for property owners to maximize depreciation and improve cash flow. The IRS Cost Segregation Audit Technique Guide, provides up-to-date information and resources for a quality study.

How Can O’Connor Help You

As a taxpayer, you will learn more about cost segregation and its operation from O’Connor’s blog series, which is based on the IRS Cost Segregation Guide. Taxpayers will have a better understanding of asset categorization, cost recovery, and depreciation methods by studying the history of depreciation. In upcoming blogs, O’Connor will discuss how to differentiate between §1245 and §1250 property tests and how cost segregation affects building systems. Work with O’Connor’s cost segregation experts to assist you in conducting a successful cost segregation study for your real estate.

The post Cost Recovery Systems that Changed Depreciation Today  appeared first on O'Connor Cost Segregation.

HOW DOES A COST SEGREGATION STUDY WORK?

A commercial real estate asset is a single entity made up of its various components, both interior and exterior to the asset itself. On average, 20% to 40% of those interior and exterior components fall under tax categories which may be written off much quicker than the building structure itself. A CSS dissects the property, determining the components that are eligible to be depreciated more quickly (i.e. 5, 7 and/or 15 years), as well as those that should be depreciated long-term (over either 27 ½ or 39 years depending upon asset type). The study allows you to accelerate depreciation deductions, thus reducing taxes and increasing cash flow. Due to enhancements to certain depreciation-related breaks under the Tax Cuts and Jobs Act (TCJA), the potential benefits are now even greater thanks to 100% Bonus Depreciation.

WHEN SHOULD A CSS BE CONDUCTED?

Many investors are a bit confused as to when to undertake a cost segregation study. Owners that acquire, construct or substantially improve a building, or did so within the previous year, should consider a cost segregation study. Additionally, if you are just learning about cost segregation, note that you have not necessarily missed out on an opportunity. The IRS allows us to perform “Look Back” studies on assets that you have acquired or constructed in previous years. Though Look Back studies are available, the best time to do a cost segregation study for new owners is during the year a building is constructed, remodeled or purchased, and BEFORE federal income taxes are filed for the ownership entity. This avoids the need for special form submission (form 3115), helping to limit out-of-pocket expenses.

To learn more about the cost segregation study, connect with us at Expert Cost Segregation.

The post When is the right time to do cost segregation study? appeared first on O'Connor Cost Segregation.

Cost Segregation is not a new concept, but provisions contained within the Tax Cuts and Jobs Act of 2017 have ignited interest and turbo-charged the positive impact significantly.  The point source for these changes?

Bonus Depreciation!

Let’s take this a step at a time and start with a basic question.  What is depreciation?

Simply put, depreciation is an accounting tool which allows a portion of your asset value to be deducted each year from your generated income, thereby reducing your net income and resulting federal tax burden.

This provides an acknowledgement of the decrease in value of personal property and/or some real property due to wear and tear, aging, functional obsolescence and other factors.

For a long time, straight-line depreciation was practiced, and still is in many instances.  This allows you to depreciate your asset over 39 years for standard commercial assets, or over 27.5 years for apartments.  Here is an example using rounded numbers for a small office building:

Purchase Price  $2,000,000

Land Value  $400,000

Depreciable Basis of Improvements  $1,600,000

Annual Depreciation  $41,025 ($1.6M / 39 years)

So, in the example above, when filing your income taxes for the ownership entity of the asset, you would be able to deduct $41,025 in depreciation from generated income.  Since this in essence comes right off your bottom line, you would effectively save over $15,000 in taxes (based on a 37% tax bracket) by utilizing straight-line depreciation.  Not bad at all!

Enter Cost Segregation!

Cost Segregation has been around for decades in various forms and iterations, as far back as the late 1950s (Shainberg vs. Commissioner), then on through the 1970s (Revenue Ruling 73-410; Whiteco Industries vs. Commissioner); the 1980’s with the enactment of ACRS and subsequently with MACRS (Modified Accelerated Cost Recovery System) in 1986, impacting assets placed in service after January 1, 1987.  It has been continually refined and tweaked by various court cases (notably Hospital Corporation of America vs. Commissioner in 1997).

Cost Segregation provides a way for a knowledgeable individual to break out the components of an asset into the appropriate depreciation life span, allowing for shorter recovery periods and accelerated depreciation.  In most instances, this involves parsing the asset into 5, 7, and 15 year depreciation periods, with the remaining long life assets being broken out into the requisite Units of Property as provided for in the 2014 Tangible Asset and Repair Regulation dictates.

Let’s get back to our original example to show the positive effect of Cost Segregation on your bottom line.

Purchase Price  $2,000,000

Land Value  $400,000

Depreciable Basis of Improvements:

• 5 Year Assets  $192,000
• 7 Year Assets  $8,000
• 15 Year Assets  $208,000
• 39 Year Assets  $1,192,000

Annual Depreciation  $80,868*

*NOTE that this figure is an average depreciation figure over the first five years of the use of Cost Segregation.  Due to the varied nature of the depreciation calculations based on the recovery period, it is impossible to provide a completely accurate number for one year for comparison purposes.

That’s roughly DOUBLE the depreciation you can expect from straight-line depreciation, and could lead to bottom line tax savings of almost $30,000 in the same 37% tax bracket.

And finally, BONUS DEPRECIATION!

Sorry for the delay, but we are finally at the main point!  The Tax Cuts and Jobs Act of 2017 contained a provision allowing for 100% Bonus Depreciation for any commercial, for-profit asset placed in service or purchased after September 27, 2017!

This means that for any portion of the asset with a depreciation-life of 20 years or less, 100% of the value can be depreciated in the first year of ownership! Read what the IRS is saying about bonus depreciation here.

For most commercial properties, we typically find assets with a depreciation life of 5 years, 7 years and 15 years, along with the 39 year depreciation life, during the course of our cost segregation studies. Given the new laws, any assets found in those shorter depreciation life categories can be depreciated 100% in the first year of your ownership of the asset.

This can amount to between 25% and 45% of the total asset value, depending upon our findings during the site inspection!

Let’s look at our previous example through the lens of 100% Bonus Depreciation:

Purchase Price  $2,000,000

Land Value  $400,000

Depreciable Basis of Improvements:

• 5 Year Assets $192,000
• 7 Year Assets $8,000
• 15 Year Assets $208,000
• 39 Year Assets $1,192,000

First Year Annual Depreciation  $408,000

That’s about 10 times the first year depreciation available via straight-line depreciation, and more than five times that available from standard cost segregation!  In a 37% tax bracket, that equates to just over $150,000 in positive bottom line impact potential!

I’ve purposefully kept these figures on the low side of our findings continuum, with the 100% bonus depreciation representing roughly 25% of the depreciable basis.  We often find much more!

The new tax law allows the use of bonus depreciation for only a few years. If you are interested in taking advantage of the new tax laws, protecting your bottom line, and maximizing your cash flow, act now. You may contact here us and request a free preliminary evaluation.

Check out our quick and free tax savings calculator to see how much you can save with a Cost Segregation study using bonus depreciation.

The post How commercial property owners can use bonus depreciation to reduce income taxes appeared first on O'Connor Cost Segregation.

Active real estate investors can legitimately increase depreciation, and thereby significantly enhance cash flow, through the use of a quality cost segregation study.  An intelligently executed and properly prepared cost segregation study can provide real estate owners with an IRS-sanctioned cash windfall.  Cost segregation studies identify short-life depreciable components, categorizing them as 5-Year, 7-Year or 15-Year depreciable life assets, and allows for not only the shorter depreciation life, but accelerated depreciation via the use of a 200% declining balance for the 5 and 7-Year components, and a 150% declining balance  for the 15-Year components.  The result is significantly increased depreciation in the early years of asset ownership, offsetting much of the income derived from the property.

Short-life depreciable components are plentiful on most properties and can represent from 20% to 40% of the total cost of the asset.  Here is a short list of examples of each short-life category:

• 5-Year: carpeting; vinyl tile; window coverings
• 7-Year: kiosk/cluster style mailboxes; park benches
• 15-Year: landscaping; parking lots; sidewalks

One of our clients recently asked us to perform a cost segregation study on a newly acquired multifamily asset.  Working with their depreciable basis of just under $20,000,000, we identified over 38% of the basis as short-life depreciable components, generating almost $1,000,000 in additional depreciation and more than $385,000 in potential tax savings in the first year of study use.  Over the first five years, those potential tax savings may top $1,600,000!  That is money that can be rolled back into the property for improvements, distributed to partners, or utilized as seed money for the next purchaseRedirection.

Correctly identifying, valuing, and documenting the short-life components is critical for a quality cost segregation study.  The IRS, in their IRS Field Audit Techniques Guide, publishes checklists for a quality study and a quality cost segregation report.  As long as the study complies in all areas with the IRS guidelines, it can be used to legitimately increase your depreciation and reduce your taxes, thereby enhancing your cash flow and bottom line!

The post Top Way to Reduce Income Taxes for Commercial Property Owners appeared first on O'Connor Cost Segregation.

Depreciation is an important non-cash tax deduction. By increasing tax deductions, commercial property owners affect federal income tax reduction. The increase in tax write-offs generates such a large tax cut that some wonder if it is a tax shelter or tax evasion scheme. It is not. Cost segregation is an IRS-guided process used to increase tax deductions during the tax preparation process. Commercial real estate owners seeking tax advice and tax relief can benefit from reviewing the tax relief available from cost segregation.

Benefits of Cost Segregation Analysis

Benefits of a cost segregation study are substantial, immediate and enduring. Year 1 federal income tax savings are typically at least two times the cost of a cost segregation study. In many cases they are five to fifty times the cost of the study. The present value of federal income tax savings for a property held for ten years are typically at least ten times the cost of the study. In many cases, the present value of tax savings as much as 30 to 50 times the cost of the report. The cost segregation study is only required once. Its cost is not recurring, but the benefits are recurring during the term of property ownership. A cost segregation study can also materially reduce local property taxes by separating real and personal property for newly constructed properties.

Detailed Example

Preparing a cost segregation study requires only a limited time commitment from the owner, perhaps 10 to 15 minutes. This limited commitment of time results in substantial federal income tax savings, which are both conservative in approach and well documented. Some owners believe their accountant is properly segregating components into the proper classifications. Many accountants and tax lawyers cannot thoroughly research this highly specialized field to understand the myriad number of items which can be segregated and are inadvertently overstating their client’s income tax liability. Furthermore, not obtaining a cost segregation study increases exposure in case of an audit since there is no clear audit trail. A cost segregation study prepared by an appraiser with expertise in land valuation, construction costs and market value clearly documents each of these items. Further, a cost segregation expert can almost certainly sharply increase allowable depreciation.

Following is a summary of the results of a cost segregation study based upon a recent assignment: Office Building

Cost Segregation Example

Annual depreciation (using 39-year straight line) $137,756

Accurate Cost Allocation and Depreciation after Cost Segregation Study

Who Benefits from a Cost Segregation Study

If you own real estate and pay federal income taxes or expect to during the ownership period for the property, you will benefit from the results of a cost segregation study. This is true whether the owner of the real estate is a corporation, limited partnership or limited liability corporation. For syndicators, a cost segregation analysis is appropriate if limited partners will receive material net taxable income during the holding period even if the general partner does not currently pay federal income taxes. The cost segregation study will increase depreciation shield, thereby decreasing and deferring federal income taxes for the investors.

Decreasing and Deferring Federal Taxes

Since a cost segregation study decreases and defers federal income taxes, let’s review the long-term impact of this deferral. When the property is sold, capital gains tax will be due if the owner does not enter into a 1031 exchange. However, capital gains tax rates are typically 15% for high net worth individuals, while the ordinary income tax rate is 35%. In addition, the deferral during the ownership period has material benefits because of the time value of money. All investors would much rather pay a 15% tax rate when an asset is sold as opposed to paying a 35% tax rate today.

When Should You Obtain A Cost Segregation Study

The best time to obtain cost segregation services is when you build or purchase a property. Documentation is most readily available for performing a study and a contemporaneous property inspection can be performed to best document results. However, there are options to perform a cost segregation study for property which has been developed or purchased previously.

Elements of Preparing a Cost Segregation Study

The appraiser starts by gathering documents from the property owner and performing a site visit. As necessary, depending on the special-use property found during the site visit, the appraiser would confer with tax counsel and review relevant tax court decisions. For newly constructed properties, most of the information on actual costs can be obtained from construction draws or invoices from contractors. For existing properties, the appraiser performs a quantity take-off for 5-year, 7-year, and 15-year property and estimates replacement cost using recognized sources. The appraiser then values land, 5-year, 7- year, 15-year, 27.5-year and 39-year property based upon inspection, analysis and IRS regulations and court rulings.

Does This Only Apply to Large Owners?

Both large and small owners of income property or owner-occupied commercial property can benefit from a cost segregation analysis. Commercial properties with a cost basis of at least $200,000 will likely see a material benefit in excess of the cost from a cost segregation study. In fact, owners of single-family rental homes can probably achieve worthwhile benefits by obtaining a cost segregation study.

Qualifications to Consider When Ordering a Cost Segregation Report

The ability to value land and real property are critical elements when engaging a tax reduction expert to perform a cost segregation analysis. In addition, it is essential they have a detailed understanding of rules for classifying 5-year, 7-year, 15-year, 27.5-year and 39-year property. The ability to justifiably increase short-life depreciation materially increases the benefits of a cost segregation study. While most accounting professionals have a rudimentary understanding of the 5-year, 7-year and 15-year property classifications, few have a detailed understanding of this highly specialized niche. Be certain the report provider has scrutinized both the federal income tax code and the meaningful tax court cases to allow you to maximize your depreciation and minimize your federal income tax liability.

More tax deductions means tax reduction

Important Commentary for Owners of Real Estate
By Patrick O’Connor, MAI

The post Cost Segregation Analysis: Depreciate Property Correctly & Pay Less Federal Tax appeared first on O'Connor Cost Segregation.