Articles & Publications: Cost Segregation
Money Could Be Hidden in Your Exam Room Walls
Your Healthy Practice, Winter 06
by Lou Camarella
Are you the proud owner or part owner of a medical office building, surgery center or other professional building?
If you aren’t depreciating your property as quickly as permissible under current law, you may be grossly overpaying your federal income taxes. Cost segregation can help. What is cost segregation?
Cost segregation is a viable means of increasing cash flow through accelerating the depreciation of building costs. A cost segregation study enables property owners to benefit from faster write-off of building costs and defer federal income taxes, generating significant cash-flow savings.
When properly performed by an engineering firm with expertise in cost segregation, this conservative tax planning tool reduces federal income taxes by appropriately allocating the cost basis among land, real property and personal property. Who should consider a cost segregation study?
Owners, partners, investors and shareholders who have constructed, acquired or renovated real estate costing $1 million or more since 1987 should consider cost segregation. High-tax-bracket real estate investors who are not planning to sell soon can generate cash flow benefits from the property on their balance sheet. What are the benefits of a cost segregation study?
Under current law, all commercial buildings, whether constructed or acquired, are depreciated over 39 years. Residential apartments and extended-stay hotel buildings are depreciated over 271/2 years.
An engineering-based cost segregation study is a powerful and strategic tool that identifies parts of real estate property that qualify for accelerated depreciation. These include personal property with five- to seven-year depreciable life and land improvements with 15-year depreciable life. These additional periods allow real estate owners to maximize their depreciation deduction.
Every dollar that’s segregated from 39 years to five years is worth 22 cents on the dollar. The increased depreciation expenses reduce taxable income and result in increased cash flow because the owner pays less income tax during the early stages of a building’s life.
A cost segregation study allows taxpayers to accelerate certain components that were installed during the construction, renovation or expansion that are related to the taxpayers’ business and not necessary to operate a building.
For example, the cost, including labor and materials, for a plumber to install a 1/2-inch copper line to an exam room or surgery room sink can be depreciated over five years. A 1/2-inch copper line installed by the same plumber to a bathroom sink is depreciated over 39 years.
If you apply this concept to the plumbing, electric, HVAC and certain interior finish costs, you can reclassify 15 percent to 50 percent of construction costs to five-year depreciation.
If you have not already identified a property’s short-life components, you can “catch up” depreciation in the first year that you perform the cost segregation study without amending prior tax returns. Your CPA prepares a Form 3115 (application for accounting change) to change to the depreciation methods supported by the cost segregation report. Example: An ambulatory surgery center that was purchased five years ago for $8 million has a land value of $1.6 million. The analysis without cost segregation assumes all the value for improvements is placed on the building.
The analysis with cost segregation estimates a value of $1.28 million for the five-year property, $320,000 for the seven-year property, $640,000 for the 15-year property and $4.16 million for the 39-year property.
Over the 39-year tax life of the property, the net present value of the tax savings is $450,000, assuming an 8 percent discount rate and 40 percent tax bracket. The first year’s tax savings resulting from the combination of the one-year catch-up and the accelerated depreciation amounts to $600,000.
The benefits of performing a cost segregation study often outweigh the cost by factors of 10 times or more. A cost segregation study could save thousands of dollars in taxes. Who should perform the study?
To achieve maximum benefits under the current tax, the cost segregation study should be performed by qualified engineers who have experience in construction materials and methods. They should have current knowledge of all revenue procedures and tax laws that might impact the results or benefits of a cost segregation study. In addition, they should have experience successfully defending their cost segregation studies before the IRS.
A comprehensive report should be prepared that is supported by a paper trail of work papers based on a site assessment of your property, a review of architectural drawings, contracts and invoices, and other documentation gathered during the study. When this expertise is combined with the skill of a CPA who knows your tax situation, the result is a reliable report that delivers substantial tax savings.
Written by Louis J. Camarella, Jr., StoneBridge Business Partners, and Michael P. Morris, Ernst & Morris Consulting Group, Inc.
Louis J. Camarella, Jr., CPA/ABV/CFF, ASA, MBA
Lou is one of the founding partners of the firm’s Business Valuation, Forensic & Litigation Services Group and he currently is the Managing Director. He is also one of the founding members of StoneBridge Business Partners, an affiliated consulting firm. Read more about Lou.