Download Real Estate Cost Segregation

Tax Saving Strategies
Cost Segregation Studies for Commercial and Residential Rental Properties
What is Cost Segregation?
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Smart tax strategy for commercial and
residential investment property owners
Allows property owners to access taxpayerfriendly changes to tax law
Property owners find a friend in the IRS
Goal of Cost Segregation Studies
Free up money trapped in the walls of the building
per the IRS Audit Technique Guidelines
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Goal = to identify all construction-related costs that
can be depreciated over 5, 7 and 15 years and
reclassified from 39, 31.5 and 27.5 years
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Traditional depreciation for Real Property is 39 years
for commercial property and 27.5 years for residential
rental property
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Personal property is depreciated much quicker and can
be depreciated over 5, 7, 10, and 15 years
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Reducing tax lives results in accelerated depreciation
deductions, a reduced tax liability, and increased cash
flow
The Time Value of Money – Win the
money game!
Albert Einstein is quoted as saying:
"compounded interest is the 8th Wonder of the World - It
can work for you, or against you. When you retain it, it
works for you. When you borrow it works against you!
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Learn To Master The Compound Interest Calculations
Now look at what happens to your money each time it
doubles...
$1 ... $2 ... $4 ... $8 ... $16 ... $32 ... $64 ... $128 ...
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Win The Money Game!
Leverage old money you are already spending to
create new money you can invest. By lowering
your tax payment you free up cash, which you can
then invest. Your goal is to have compound
interest work for you and not against you.
Defer, Defer, Defer
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As Benjamin Franklin said, "In this world
nothing is certain but death and taxes."
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While both death and taxes may be
inevitable, we are constantly challenged
to figure out a way to defer both. The
potential value of deferring taxes is one
of the primary reasons there is such a
growing interest in cost segregation.
Free-up Trapped Money
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Traditional depreciation for Real Property is
39 years for commercial property and 27.5
years for residential rental property
Personal property is depreciated much quicker
and can be depreciated over 5, 7, 10, and 15
years
What Are The Benefits?
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Generates immediate increase in cash flow
through accelerated depreciation deductions
Reduces income taxes and real estate property
taxes
Provides an easy opportunity to claim “catch up”
depreciation on previously misclassified assets
Provides an independent third-party analysis
that will withstand IRS review
Benefits Bank Loan Qualifications
Seizing Tax Savings
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Identify the parts of a building that qualify as
personal property and depreciating these parts
separately from the rest of the property
Accelerates federal tax depreciation on
segregated components, reducing current
income tax payments and increasing net cash
flow
Additional Benefits
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Pre-Construction Planning: In the design phase,
Cost Segregation can help make the building more
tax efficient by identifying business components
from the structural components
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Property Tax: Property taxes are calculated as a
percentage of the building costs. In any real estate
investment, personal property should be accurately
removed from the cost of structural components and
not to be recorded as part of the property tax
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Insurance Company: Cost segregation can
identify the cost of non insured properties, and
therefore reflect more accurately of the insurance
covered properties and reduce the insurance cost
Additional Benefits
Real Estate Investment Trusts (REITs)
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May identify up to 30% of their building’s
component costs as tangible personal property
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qualifies for accelerated depreciation
Can substantially increase depreciation charges
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provides increased cash flow for additional
acquisitions
Additional Benefits
Demolition/Rehabilitation
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Ability to identify components of a building
prior to demolition/rehabilitation which can
be reclassified as personal property versus
real property
Allows the owner to write off these items
versus capitalizing the assets which generate
a substantial tax savings
Additional Benefits
Not For Profit Corporations
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Increase depreciation expense for book
reporting purposes which allow the retention of
cash versus distributions to members
Items To Be Accelerated
Items which can be reclassified include:
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Site Improvements (landscaping/parking)
Light Fixtures
Branch wiring
Potential Plumbing
Flooring
Millwork
Millwork Window Coverings
Partition Walls
Cabinetry
Furnishings
Shelving
Wall Coverings
Irrigation Systems
Items To Be Accelerated
Factors that now govern whether property is
permanent or can be reclassified:
Permanency test - Sec. 1.48-1 (c)
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Is the property capable of being moved?
Has it been moved?
Is the property designed or constructed to remain
permanently in place?
Are there circumstances which tend to show the expected or
intended length of affixation - i.e. may or will be moved?
How substantial of a job is removal of the property & how
time consuming?
Is it readily movable?
How much damage will the property sustain upon removal?
What is the manner of affixation of the property to the land?
Qualified Property
Primary and Secondary Electrical Distribution Systems
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Property to include:
 Main panels
 Motor control centers
 Transformers
 Main distribution panel switchgear
 Related wiring and conduit
The courts conclude that the portion of the cost of the
primary and secondary electrical distribution systems which is
equal to the percentage of the electrical load carried to those
systems allocable to the property equipment, as stipulated
constitutes the 1245 qualification class property and is
depreciable over an accelerated life.
Qualified Property
Branch Electrical Wiring and Connections, and Special
Electrical Equipment
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Property to include:
 Controls
 Battery packs
 Battery chargers for emergency power equipment
 Illuminated emergency and entrance signs
 Medical gas control and alarm equipment
 Kitchen equipment
 Wired clock systems
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Normally 100% of the load carried relates to this type of
equipment, therefore the balance of the electrical is
normally allocated to the building
Qualified Property
Wiring and related Property Items Relating to
Television Equipment
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Property to include:
 Branch electrical wiring
 Conduit, floor boxes
 Junction boxes
 Outlet receptacles
 All other equipment in connection with its
operation
Qualified Property
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Electrical Wiring Relating to Internal Communications
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Property to include:
 Conduit
 Wiring
 Electrical connections
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Systems supported:
 Call systems
 Intercommunication systems
 Dictation systems
 Music systems
 Paging systems
Qualified Property
Carpeting
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Carpeting is normally custom fit
Installed over the sealed concrete floor using
adhesives
Not permanent or re-used
Quick removal with little to no damage to the
underlying structure
Income tax Reg. Section 1.48-1(e) (2) does not list
carpeting as a structural component nor as an integral
part of the floor itself
Qualified Property
Vinyl Wall Coverings
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Vinyl wall coverings are not intended to remain as a
permanent or integral part of the structure
Can be easily removed
Applied using adhesive which is expressly recognized
as being non-permanent
Are decorative in nature
The adhesive rule is the catch – S. Rept. 95-1263,
1978-3 C.B. (Vol. 1) at 415 specifically states that
items adhered to a surface using stripping adhesive
are non-permanent
Qualified Property
Vinyl Floor Coverings
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Vinyl floor covering and matching base cove molding
is also attached by using adhesive
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Subject to Section 1245 property depreciable over
accelerated recovery periods
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Pursuant to S. Rept. 95-1263, 1978-3 C.B. (Vol. 1) at
415
Qualified Property
Kitchen Plumbing
Property to include:
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Items relating to operation of grease trap systems
Trench drains
Grease waste piping
Waste excavation
Waste fill
Trap itself
All connections (hose and reel connections)
Water piping used for operation of kitchen
equipment
Qualified Property
Kitchen Hoods and Exhaust Systems
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Property to include:
 Air intake fans & related duct work
 Dishwasher condensate return units
These items ventilate air, remove humidity and steam,
replace air expelled
Test:
 Do the items relate to the buildings operation or
maintenance?
 NO! Therefore are considered Section 1245
property
Qualified Property
Partitions
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Property to include:
 Accordion-style room dividers
 Decorative lattice millwork used to separate areas
These items are not permanent structures therefore
do not affect the operation nor maintenance of the
building
1245 property
CSS Brief History
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Cost segregation studies began during the 1980's as a means
to help developers of new property obtain special investment
tax credits for personal property contained in the buildings
In 1997, the US Tax Court ruled in favor of Hospital
Corporation of America (HCA), that property qualifying as
tangible personal property under the former ITC rules would
also qualify for purposes of federal income tax depreciation.
HCA is considered a landmark decision for owners of
commercial properties
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In 1999, the IRS released Legal Memorandum 19921045 in
which the IRS agreed not to contest the (HCA)
reclassification of building costs into different asset
categories that result in shorter depreciation lives
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This legal memorandum directs agents to verify that an
engineering or architectural study has been done to identify
portions of the building's system not related to the operation
and maintenance of the building. Without these detailed
studies, IRS agents are advised NOT to accept the
reclassifications
Myths of Cost Segregation
“Why hasn't my accountant told me about
Cost Segregation?”
 Most CPA firms do not have experienced cost
segregation or partner with engineers and
architects to physically inspect the property,
examine architectural/engineering drawings and
analyze cost data. Without engineering
expertise, clients will often miss substantial
portions of a building to achieve tax savings.
 Cost Segregation is a cutting edge tax saving
strategy. We carefully follow new tax laws in
this area
 We have partnered with Quantum Engineering
Associates Inc.(QEA) to offer CSS to our clients.
Myths of Cost Segregation
“Will a cost segregation study raise
suspicion with the IRS?”
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Engineering-based cost segregation studies to
classify depreciation are an accepted standard
approved by the IRS
Our experience in conducting successful cost
segregation studies means your report will
withstand IRS scrutiny
F&D/QEA team is experienced in segregating
costs and applying judicial decisions, IRS rulings
and regulations to your situation
Myths of Cost Segregation
“Why do we need an Engineer in our team?”
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Without the contractor/engineering expertise
coupled with the CPAs tax law guidance, there
will likely be valuable tax benefits left on the
table
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Without a complete Engineering and Tax Law
study the depreciation changes will not
withstand IRS scrutiny in accordance with the
IRS Audit Technique Guidelines
Myths of Cost Segregation
“We'll get the deduction in the future anyway,
without a cost segregation study...right?”
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You can have the cash now for investments or
to meet current needs.
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The present or future value of money is usually
substantial
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Yes, but a cost segregation study gives you an
interest free loan from the government
for the first 15 years, which you will then repay
interest free over the remaining 25 years.
Who do you want holding your money?
Myths of Cost Segregation
“I’ll owe taxes when I sell the building”
Taxes are due when a property is sold,
except with CSS, your deduction will not be
at ordinary rates and a majority of the taxes
due will be at capital gain rates. This can
result in a lower tax rate difference of 16%
at the highest marginal tax rates.
Myths of Cost Segregation
“I am out of luck because the building was
constructed or acquired in prior years”
Special provisions enacted by the IRS allow you
to “catch-up” on any missed depreciation for any
buildings built or acquired since 1987
Do I Qualify?
You would benefit from a cost segregation
study if you…
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Constructed your buildings and facilities since
1986
Acquired your buildings and facilities that were
constructed before 1986, but acquired in a
taxable transaction after 1986
Renovated your building after 1986
Made additions to your buildings after 1986
Who Can Benefit
Properties with the highest savings potential include:
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Airport Hangars
Apartment Buildings
Automobile Dealerships
Automobile Service
Centers
Banks
Restaurants
Day Care Centers
Department Stores
Distribution Centers
Fitness Centers
Industrial
Hospitals
Hotels
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Laboratory/Research
Facilities
Manufacturing and
Processing Facilities
Marinas
Medical/Surgical Facilities
Nursing Homes/Assisted
Living Facilities
Office Buildings
Post Office
Resorts
Restaurants
Shopping Center
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Warehouses
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Cost Segregation Results
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Project: 25 Apartment Complexes
Cost: $188,100,000.00
Net Present Value Savings: $10,585,222
Project: Assisted Living Facility
Cost: $5,234,125
Net Present Value Saving: $625,678
Project: Hotel
Cost: $7,123,456
Net Present Value Savings: $812,145
Net Present Value assumes a 39 year holding period, a
5% discount rate and a 35% tax rate
Example
Mortgage Pay-down Illustration
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The cost basis of the property is $10,000,000
The Net Present Value Savings is projected to be
approximately $1,002,973
The cost to recapture your tax dollars now being
held at the IRS is: 3.2%
Put another way, the return on your times over 10
years, the investment is: 31.3%
The annual interest rate required to grow an
investment to that level is: 46.8%
Example
Mortgage Pay-down Illustration Continued…
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If you applied the yearly tax savings to pay down
the current mortgage, you could save an
additional
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$2,051,424.00 in mortgage payments over the
term of the loan
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You could also eliminate 4.3 years of mortgage
payments
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This savings is derived from having not to make
51 mortgage payments of $59,278 each
Example
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Investment Illustration
If you invested the tax saving annually at 5%,
the savings would grow from $196,510.00 to
$1,418,623.00 over the next 10 years
Froehlich & De La Rua Firm
Advantage
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We have partnered with Quantum Engineering
Associates, Inc who Specialize exclusively in
cost segregation services since 1989.
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We have experience with cost segregation
cases with assets over $50M
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We take a rigorous engineering and
architectural approach, the very type of
approach approved according to the IRS
Guidelines
Froehlich & De La Rua Firm
Advantage
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Driven to unearth the most opportunities for tax savings
on your behalf
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We prepare and deliver a thorough written report
including spreadsheets segregating project costs into
commercial/residential real estate, land improvement or
personal property per IRS audit guidelines.
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We understand applicable Internal Revenue
Code, Tax Court Rulings, IRS Actions on Decisions,
Chief Counsel’s Advisories, Technical Action
Memoranda, and other documents relating to
depreciation of personal and real property
Summary Cost Segregation
Benefits
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Dramatic deduction in taxable income
Increased cash flow for investment
opportunities and business expansion
Property tax savings
Insurance savings
Real Estate Agents, Mortgages Brokers and
Contractors can offer Cost Segregation option as
a value added service
Retention of $ in Palm Beach County from
business owners in 2005 could reach
$24,017,000
Contact Information
John F. Froehlich
Betty De La Rua
 Accounting
 Taxation
 Assurance
 Business Consulting
 Cost Segregation Studies for:
o Commercial Real Estate
o Residential Real Estate
12008 South Shore Blvd., Suite 210, Wellington, FL, 33414
P: (561)795-9500
/ www.froehlichcpa.com
/ Spanish & Portuguese