Many commercial real estate professionals are familiar with the basics of cost segregation, but few have taken full advantage of the possible opportunities it may yield. In recent years, important regulations have expanded the utility of cost segregation and related services, resulting in more ways to capture deductions than ever before.
To illustrate the diverse applications of engineering-based tax strategies, let’s walk through a few scenarios using the same theoretical property.
- Office building purchased and placed-in-service in 2010.
- Building is 4 stories and 100,000 SF.
- Multi-tenant building, primary tenant occupies 40% of the square footage.
- Property acquired for $12M, after subtracting a $2M land allocation, the basis is $10M.
SCENARIO ONE: Owner acquired property in 2010 and had CSS performed upon acquisition in 2010.
SCENARIO TWO (LOOK-BACK): Owner acquired property in 2010 but did not have CSS performed until 2016.
|Scenario One – CSS performed in 2010
|Scenario Two – Look-Back CSS performed in 2016
|Year One Tax Savings
|10 Year Net Present Value
As you can see, cost segregation is a powerful tool whether performed immediately after the property was placed-in-service or several years later. The economics of the Look-Back study are indeed superior in comparison to the results of the Scenario One study. However, the Scenario One taxpayer would have had access to the additional cash flow starting in 2010, while a taxpayer electing to perform a Look-Back study would not have this advantage. This is the essence of cost segregation, with either approach being beneficial, and the time value of money playing a major role. The decision ultimately depends upon the tax position and strategy selected for each entity.
SCENARIO THREE: Owner acquired the property in 2010 and had CSS performed immediately after the acquisition. It’s now 2016 and the primary tenant has vacated his 40,000SF which will be gutted and renovated completely.
- Landlord is paying $100/SF for Tenant Improvements (TI) = $4M
- Other Improvements to be implemented simultaneously:
- Sealcoating parking lot $200K
- Refreshing the lobby $100K
- Replacing two exterior metal service doors at a cost of $1800 each
Our approach to this scenario will highlight the enhanced functionality of cost segregation when performed in the context of the recent Tangible Property Regulations. A series of crucial regulations that clarify the expense vs. capitalization decision process, the TPRs also provide for Partial Asset Disposition elections and establish three diverse “safe harbors” under which to expense assets. Decisions of this nature require more detailed data than that generated by the average cost segregation study. Unit of Property studies provide the aggregated cumulative data required to support these decisions, and as such Unit of Property studies are typically included in a cost segregation analysis.
If an updated CSS study (including UoP) was performed on the renovated space, the following strategies could be applied:
|The $4M spent on TI is clearly a Betterment according to the BAR test and therefore must be capitalized, though depreciation will be accelerated as much as possible by reclassifying depreciable assets into shorter-lived categories. Furthermore, the recent PATH Act made permanent the 15-year straight line depreciation status of Qualified Leasehold Improvements like these, and established bonus depreciation of 50% for 2016, increasing the potential savings.
|Sealcoating parking lot
|The 200K spent on sealcoating is deductible under the Routine Maintenance Safe Harbor established by the TPRs, as it is considered “preventative maintenance that is an essential part of the ongoing care and upkeep of a building” that needs to be performed at least every ten years.
|The 100K spent to refresh the lobby is not considered a Betterment, Adaptation, or Restoration under the BAR test, and is not material to its UoP. As such the full amount is deductible.
|Metal Service Doors
|Under the De Minimus Safe Harbor established by the TPRs, taxpayers can deduct amounts used to purchase tangible property. Last year’s Notice 2015-82 increased the deduction threshold for taxpayers without an AFS to $2500 per item substantiated by invoice. As such, the cost of each of the $1800 metal service doors could be deducted in full.
|The remaining depreciable basis of the gutted assets can be written off using Partial Asset Disposition under the TPRs. Using an industry average of $30/SF of gutted asset and a 40,000 SF space, the total value of the gutted assets is $1.2M. Assuming all assets were 39-year, 33 years of depreciation remain on the books. $1.2 x 33/39 = a remaining depreciable value of over $1M, which translates to an actual tax savings of $400,000.
The overwhelming amount of favorable regulations referenced above demonstrate that there has never been a better time to explore the world of engineering-driven tax strategies. The professionals at Capstan have decades of experience helping CPAs and commercial real estate owners maximize deductions. Feel free to contact us anytime – we’d love to discuss your personal scenario.