Natural disasters can affect practically anyone. In addition to preparing for emergencies, it’s important to know what you can do to help your fiscal recovery. While some rules and regulations are still being finalized, here are some broad issues to consider.
Cost segregation studies
You probably know that real property is broken down into land and building for depreciation purposes. Land is not depreciable and the depreciable life of real property is 27 ½ or 39 years, depending on whether it is residential or commercial.
A cost segregation study allows real property owners to break down the capitalized costs of their buildings and allocate or re-allocate building costs from longer depreciable lives to shorter depreciable lives. A cost segregation study is engineering-based and takes non-structural elements of buildings that can be depreciated over 5, 7 or 15 years and breaks them out of the building cost that will be depreciated over a longer life.
Should you consider a cost segregation study?
The principle is the same as most sound tax planning ideas. By decreasing current income and thereby deferring taxes to a later tax period, you gain financially due to the time value of money. Put as simply as possible, a tax deduction today is worth more than a tax deduction next year, and worth a great deal more than a tax deduction 30 years from now. A cost segregation study provides accelerated depreciation deductions resulting in lower taxes upfront and greater cash flows. In addition, the law allows property owners to capture depreciation retroactively, as far back as 1987, providing the opportunity for even more benefits. This means a substantial influx of cash, thanks to the decreased tax burden. While deferred tax will have to be paid in later years, this essentially amounts to an interest-free loan against money that will need to be paid anyway.
Cost segregation studies should be considered when purchasing, building or doing a substantial rehab of real property. Due to all the weather issues we have been having, you may be seeing more of this in the near future.
Contract wording is critical
One of our experts asked me to share with our attorney friends two items that can effect cost segregation studies.
Wording in leases for tenant allowances – the wording should include that “the allowance can only be used for improvements made to the interior of the tenant space” and “all improvements will be left behind if they leave the location”. With this verbiage in place, we can treat the property as Qualified Leasehold Improvements eligible for 15 year depreciable life and bonus depreciation.
Allocation language should be loosely written - When real estate is bought or sold, the allocation of price is preferably broken down into 2 or 3 categories. We recommend 1) Building and Attached Improvements and 2) Movable Furniture and Equipment. The Peco Food case allocation detailed dozens of items at a chicken processing plant in the closing documents. The IRS denied a cost segregation study at a later point citing that the detail was already great enough and that the buyer and seller had agreed to the allocation.
Paula Deckman is a principal based out of our Syracuse, NY office.