“Cost Segregation” by Bo Barron, CCIM
Investors buy investment property for numerous reasons, and I had a conversation with a business owner today about the benefits of owning space for his business. Some of those benefits include cash flow produced by the property, future appreciation value, and tax shelters from the IRS. However, property owners are giving too much to the IRS and missing out on real cash flow because they are not taking advantage of Cost Segregation. Substantial tax savings and realized cash flow are hidden beneath their feet, within the walls, and even in the parking lots of their buildings.
A Cost Segregation Study is an IRS approved method to reclassify original costs of construction or the purchase price of Real Property. By properly classifying costs, assets can be depreciated over, 5, 7, and 15 years as opposed to 27.5 or 39 years. These studies can do at least three things. First, it creates immediate tax savings by cutting down on what you pay the IRS this year and in upcoming years. Second, because of the accelerated depreciation deductions and the deferred income tax payments, it instantly increases your cash flow. Third, the IRS now allows you to “catch-up” previously under-reported depreciation without filing amended tax returns. This allows you to “catch-up” during your current year return with the use of a Cost Segregation Study.
Now, I am clearly not a CPA, but I do understand what drives the value of a property, and that is cash flow. In today’s market where values are decreasing and tenants are scarce, now is the perfect time to take advantage of this kind of study to increase the cash in your pocket while increasing the property’s value in the market.
So what are the guidelines, and who can benefit from this? First, the property must have a cost basis of $500,000, and new construction or purchased property can qualify – even some properties purchased as far back as Jan. 1, 1987. For tenants, leasehold improvements can also qualify, and because of the Economic Stimulus Act of last year, improvements that took place for space put into service between Jan. 1, 2008 and Dec. 31, 2009 qualify for a 50% bonus depreciation. That equates to recovering half you improvement cost in year 1. Could that make a huge impact on your bottom line? You better believe it.
Let’s look at a scenario. Mr. Big Investor buys a downtown office building for $3 million (you can now tell that I practice my craft in a small market), and allocates $400,000 to the land value and $2.6 million to the building. An office building is straight-line depreciated over 39 years for a depreciation savings of approximately $67,000 per year. However, if Mr. Big Investor conducts a Cost Segregation Study, he could potentially reallocate as much as $1 million to shorter recovery periods which could equate to $100,000 per year in deprecation as opposed to $67,000. Even though these are round numbers and estimates, it is clear how much savings could be hidden in the carpet and walls of a building. Now think how much this could save if you “catch-up” the last couple of years on this year’s tax returns. How much could this tactic save you over the next 10 years? We are talking about a significant amount of money.
If a light bulb just went off in your mind, then what should you do? You need to call two people. First, your commercial real estate advisor can help you estimate if your property could be a candidate for a cost segregation study. If it is, your next call should be to a qualified CPA who can conduct the study according to the detailed guidelines and methodologies of the IRS Cost Segregation Audit Techniques Guide.
As a business owner, investor, property owner/operator, or a tenant with leasehold improvements, you owe it to yourself to find out if your property or space can qualify. Otherwise, you are leaving money on the table, or more accurately, in the walls.