“A dollar today is worth more than a dollar tomorrow.” No corporate finance executive needs to be reminded of this old adage. While it is one of the driving forces behind financial decision making, it applies equally to federal tax planning.
Simply stated, a federal tax deduction claimed today is worth more than one claimed in the future.
Translating this cliche into the real world of bricks and mortar, let’s assume that this “dollar” is actually the cost of one of the many new manufacturing, retail or commercial office developments being constructed throughout this country, “today” is actually five or seven years, and “tomorrow” is actually 39 years. Would you rather reclaim your federal tax depreciation deductions on your company’s new building investment over five or seven years, or over 39 years?
The correct answer, while obvious, may provide a critical advantage to the savvy CFO. The accelerated depreciation results in increased current cash flow, which in turn can be used to underwrite current or future expansion. And with passage of the Job Creation and Worker Assistance Act of 2002, there are additional tax depreciation benefits available.
Properly segregating the costs of a construction project is part art, part science. Almost anyone can identify and depreciate the costs of manufacturing equipment, office furniture and fixtures, and computer equipment properly over five or seven years for federal tax purposes. However, the construction-related costs, which may account for 80 to 90 percent of the overall project cost, are all too commonly lumped together as real property whose depreciable life is 39 years.
What this means is that, for all intents and purposes, the annual federal tax depreciation deductions for a facility will be spread evenly over the next 40 years.
With this in mind then, the primary goal of a cost segregation study of a newly constructed, expanded, or acquired facility is to identify all construction related costs that qualify for shorter federal tax lives. The result of reducing tax lives from 39 years, using straight-line depreciation, to five, seven or 15 years, using accelerated methods, may have a significant impact on a company’s federal tax liability.
Benefits
What are the tax savings of accelerating depreciation? More importantly, what potential tax savings may be lost by neglecting to take advantage of accelerated depreciation? As an example, consider a typical 75,000-square-foot manufacturing facility, held in an LLC, which was placed in service in 2002 with construction costs totaling $5 million. By performing a cost segregation study, all short-lived costs can be identified, and it is reasonable to assume that 12 percent of the total construction cost will qualify as 15-year property and 15 percent of the total construction cost will qualify as personal property. The potential federal tax savings of carving out the short-lived property in lieu of depreciating the entire cost of construction over 39 years is shown above.
The true value of cost segregation really becomes apparent when you move from a light manufacturing environment to a heavy manufacturing or high-tech environment, such as research and experimentation, metal stamping and chemical processing facilities. For example, the construction cost of a high-tech chemical or pharmaceutical processing facility can range anywhere from $10 million to $50 million, and the tax savings may range anywhere from 25 to 75 times those illustrated above. The simple fact that must be remembered, however, is that there are potential tax savings for all types of construction.
Two recent developments have greatly increased the potential benefits of cost segregation. First, the Job Creation and Worker Assistance Act of 2002 signed into law in March of last year, allows a taxpayer to claim an additional first year depreciation deduction equal to 30 percent of the basis of qualified property. Generally, qualified property is defined as newly constructed property with a recovery period of 20 years or less, and which was placed in service after Sept. 10, 2001 but before Sept. 11, 2004. This additional first year bonus deduction further enhances the savings that can be achieved by classifying property as personal or land improvement property.
In the second instance, the IRS issued an important pronouncement last March that will be beneficial to all property owners. For all intents and purposes, a taxpayer may now easily rectify a past misclassification of property, which may yield a significant cumulative depreciation adjustment in the year the misclassification is corrected. What this means is that cost segregation may be applied to past construction as well as current and future construction. It is also important to point out that this generally can be accomplished without the need to amend any prior year tax returns.
Qualifications
What construction related costs qualify for shorter lives? Land improvement costs qualify for a 15-year depreciable life. Construction that improves the surrounding land is a land improvement. Examples include paving, site utilities, site electrical and landscaping. Personal property items generally qualify for either a five- or seven-year life depending on the nature of the business. These costs are not easily defined as they may be related to the equipment or operations housed within the facility, or just as easily, they may be items that are decorative in nature. Personal property examples include process equipment, support foundations and framing, process-related electrical componentry, process-related plumbing and HVAC, and in some cases, certain process-related land improvement costs.
In addition, allocating the various project soft costs, such as architectural services, materials testing services and construction-period interest, to the hard construction costs on a functional basis ensures that a portion of these soft costs gets depreciated as short-lived property.
Cost segregation offers important benefits to those building new facilities or acquiring existing facilities; however, a worthwhile word of caution is in order: While it certainly pays to be aggressive, it also pays to be defendable. With a greater focus these days on reducing our federal budget deficit, the Internal Revenue Service stands ready to pounce on the overly aggressive taxpayer. Any position taken by the taxpayer regarding the classification of construction costs as short-lived personal or land improvement property should be able to withstand IRS scrutiny.
There is a wealth of case law that deals precisely with what does and what does not qualify as short-lived property. Be cautious when exploiting gray areas, consult closely with your tax advisors, and maintain good project cost documentation. An ounce of prevention will go a long way to preserving these new found savings.
