Tax advantages and construction often go hand in hand. The key is to maximize potential benefits with astute planning. Case in point: A building owner may be able to recoup the cost of real estate through annual depreciation deductions. Usually, it is a relatively lengthy process. For residential real estate, the depreciation period is 27.5 years; it is 39 years for business or investment property. Similar rules apply to capital improvements. However, it may be possible for a building owner to recoup some costs much faster by following a cost segregation study. This could be a "selling point" for construction firms as well as a major tax benefit for any commercial building owners.

What is a cost segregation study?

Income tax savings are created by utilizing shorter asset lives that are normally embedded in a building's construction or acquisition costs (generally depreciated over 39 years using the slow straight-line method). IRS regulations provide for the use of shorter lives and accelerated depreciation for certain improvements made to commercial buildings. This allows for substantial cost savings for many types of property owners.

In basic terms, a cost segregation study identifies shorter cost recovery periods for different types of assets. The analysis begins with the Modified Accelerated Cost Recovery System (MACRS) used to depreciate building assets. For instance, a study conducted by industry experts may reclassify the cost recovery periods for certain assets to be depreciated over five, seven or 12 years. This approach combines various aspects of engineering, accounting and tax principles.

A typical cost segregation study may result in a reclassification of 25% to 50% of the building assets. This could represent a significant tax savings for building owners through faster depreciation methods.

Caution: In recent years, the IRS has become concerned about studies advocating overly aggressive deductions. It has issued a comprehensive Audit Techniques Guide to help IRS agents curb abuses in this area. Nevertheless, a legitimate cost segregation study can provide the necessary guidelines.

The cost segregation study utilizes "direct costs" like labor and materials required to construct the building as well as "indirect costs" such as architectural and engineering design fees, contractor overhead, permit fees, interest, etc. Other data (including the contractor's application for payments, change orders and other related costs and disbursements) are factored in. Indirect costs may be allocated to direct costs on a pro rata basis.

The property in question must be inspected thoroughly to develop a complete understanding of the function and nature of all the building components. In addition, the analysts conducting the study must determine the accuracy of all documentation. This is a critical element involved in the reclassification of assets.

The final step in the process is the documentation and reporting of the analysts' findings. Any calculations must be substantiated in order to withstand potential challenges from the IRS.

What qualifies for cost segregation?

This methodology may be used for new buildings or existing structures that have been acquired or are being improved. For new property, further construction information may provide detailed breakdowns of costs. IRS regulations issued in 2004 approve the use of cost segregation study after a building has been acquired.

Commercial real estate owners who plan to hold property for a few years can greatly benefit from a cost segregation study. Buried tax savings can be found in:

• New buildings presently under construction
• Existing buildings undergoing renovations, remodeling, restoration, or expansion
• Purchases of existing properties
• Office/facility leasehold improvements and build outs
• Post-1986 real estate construction, building acquisitions, or improvements where no cost segregation study was performed

Is a cost segregation study right for you?

A cost segregation study can be a valuable tax-planning tool, but it should be handled by experienced professionals. Cost segregation is a highly specialized process typically performed by firms specializing in commercial real estate services. IRS regulations, rulings, and other interpretations are complex and voluminous. The challenge is to apply this complex knowledge to your circumstances.

Daszkal Bolton LLP tax professionals are experienced in this area and have saved clients millions of dollars. Cost segregation analysis reports have also withstood IRS scrutiny. Our firm provides the highest level of quality to our clients and the highest rate of return on your investment. The higher the cost of the property, the more benefit the analysis provides.

If you would like to enhance the cash flow of your real estate assets, ask a Daszkal Bolton tax advisor for more information about a cost segregation study. Call us today at 561.367.1040 for a consultation.

Chad E. Crosby is a Senior Manager in the Tax Services Department and is based in our Jupiter office. With ten years years of experience in public accounting, he leads our tax practice in northern Palm Beach, Martin and St. Lucie counties. Chad focuses on providing solutions to technical tax problems, minimizing tax liability, identifying opportunities for profit enhancement, expense reduction, asset protection and business process improvement, and consulting on complex tax and transaction matters. He has experience with divestiture structuring, mergers and acquisitions, state, local and international tax planning and compliance, and entity structure organization. Chad's clientele includes large multi-state, international corporate and flow through entities. He primarily serves companies in the manufacturing, distribution and service industries.