Massachusetts commercial real estate owners take note: Cost segregation studies are becoming one of the hottest tax-planning strategies in commercial real estate. The study offers a tremendous opportunity to increase cash flow and defer tax payments until later years. Yet only the most sophisticated certified public accountants know much about this technique and only 15 percent of commercial building owners have taken advantage of it.
A cost segregation study (CSS) is an engineering-based study that allows a commercial building owner to accelerate a substantial amount of the depreciation deductions on a building by identifying construction or acquisition costs that can be allocated to a shorter recovery period. The basic idea is to move costs that ordinarily would be depreciated over 27.5 years to 39 years to being depreciated over 5 years to 7 years using the IRS-approved, engineering-based study as proof that the cost should be depreciated over a shorter life.
Commercial building owners in Massachusetts have started to benefit from such a study.
Initial Construction
Generally speaking, this is the easiest type of study to perform because the engineers get involved right from the beginning and have access to the architectural drawings and building invoices. For example, consider a 4-story Boston office building completed at a total construction cost of $9.6 million. Without the help of an expert certified public accountant and engineer, the building owner would be depreciating the $9.6 million cost over 39 years. With a cost segregation study, the engineers come in and examine all the construction invoices and design documents. The engineers do an on-site study where they identify, measure, quantify and photograph the existence of all the assets within the building that qualify for accelerated depreciation.
End result: By performing the study, the engineers were able to allocate $1.95 million, or 20 percent, of the assets to shorter recovery periods and save the property owner more than $427,000 in taxes calculated using the net present value method.
Property Acquisition
A CSS also may be performed when a commercial property owner acquires a property. There are two types of those studies: ones performed around the period of acquisition and ones performed after an acquisition, even if the acquisition was several years ago. That is called a “look-back” study.
For example, a local regional mall located in suburban Massachusetts recently was purchased by a real estate investment company. The 2-story mall was purchased for $25.6 million. Without a CSS, the acquisition cost would be depreciated over 39 years. Upon acquiring the property, the new owners had an engineering-based CSS performed. Using whatever initial construction data that was available from the prior owner (sometimes there is no information available) and by performing a detailed on-site evaluation and identification process that included photographing all the assets, the engineers were able to determine which assets were eligible for accelerated depreciation.
End result: A total of $9.8 million of assets (38 percent of the total cost) was determined to qualify for either 5-year or 15-year depreciation resulting in a net present value tax savings of $1.5 million over the first 10 years of the property ownership and $250,000 of tax savings in the first year.
Often when performing a look-back study, none of the construction information is available. A look-back study typically relies on the engineer’s on-site evaluation and identification of qualified assets. However, a property owner doing this type of study often can receive a terrific amount of tax savings in the first year because according to Internal Revenue Code Section 418(a), the property owner is allowed is make an adjustment to catch up on depreciation. The catch up is equal to the difference between what was depreciated and what could have been depreciation had a CSS been performed on day one. For example, a small suburban Massachusetts office building was purchased by its owners in 2000 at a cost of $10 million. At that time, the owner’s accountant began depreciating the property over 39 years. A CSS was performed in 2005. The study identified $800,000 of assets that could be reallocated to a five-year recovery period. In 2005, the property owner was allowed a catch up of more than $680,000 of depreciation which resulted in a $238,000 tax savings under Internal Revenue Code Section 481(a).
Leasehold Improvements
Tenants and landlords can take advantage of cost segregation studies when they must invest funds to fit-out a space. A typical study can re-allocate more than 30 percent of leasehold improvements, normally depreciated over 39 years, to five- and seven-year recovery periods. In addition, certain qualified leasehold improvements may be eligible for additional considerations, even retroactively.
An example of this occurred when a high-end restaurant leased and built out its space in a suburban Boston shopping mall. The restaurant owners spent more than $1.4 million on the custom fit-out of the restaurant space. A CSS was performed by an engineering team, which reviewed the construction documents and conducted an on-site evaluation of the construction. Again, assets were identified and photographed by the team and the costs of the identified assets were quantified.
In the end, $924,000 of assets re-allocated (65.2 percent) to shorter recovery periods resulting in over $236,000 on net present value tax savings over 10 years and $17,000 of tax savings in the first year.
It is easy to see why a CSS in such a powerful tax planning strategy for commercial property owners and even tenants who pay for their own fit-outs.
What types of properties can benefit from a cost segregation study? Massachusetts examples include office buildings, shopping malls, strip shopping centers, apartment buildings, large leasehold fit-outs, auto dealerships, free-standing out-parcel buildings used for large retail stores or chain fast food restaurants, hotels and resorts, distribution warehouses, manufacturing facilities and industrial buildings. Any commercial property owner looking to reduce their tax burden should consider this powerful strategy.
