Cost Segregation: A Tax Advantaged Analysis of Real Estate and Leasehold Improvements

In an economy where cash is king, more than ever before, companies can minimize their tax liability and increase their cash flow through properly classifying building and/or leasehold improvement construction or acquisition costs into lives shorter than 27 ½ and 39 years (the typical recovery period for real property).

Although results will vary depending on the type of property, the additional deductions in the first two years from a cost segregation study can total over $700,000 for every $1 million in assets reclassified from 39-year to 5-year property. Further, the results of a cost segregation study can be used to reduce state and local property taxes, resulting in a permanent tax benefit. Finally, because cost segregation is generally associated with commercial property, any entity owning real estate or leasehold improvements can benefit from a cost segregation study—regardless of the industry.

What is Cost Segregation?

Cost segregation is an IRS recognized technique of combining tax and engineering strategies to identify and segregate the costs of "short-lived" property from real property. Short-lived assets are not always apparent. In certain instances the costs for plumbing connections, electrical infrastructure, site improvements and heating, ventilation and air conditioning systems, which would otherwise be considered real property, qualify for shorter tax recovery periods. Through a detailed and systematic accounting and engineering-based analysis, entities can be provided with substantial tax benefits in the proper identification and segregation of assets related to new construction, purchased property, remodeled/expanded property and existing real estate placed in service in prior years.

Current Tax Law: Extension of Bonus Depreciation and Qualified Leasehold Improvement Property (QLHI)

Prior legislation granted taxpayers an additional 50% bonus depreciation for property with lives of 20 years or less placed in service during 2008 and 2009. This translates into a 60% deduction of 5-year property basis in the first year.

This tax advantage is not limited to real property owners, as tenants can also benefit from a cost segregation study. If your company constructed leasehold improvements during either 2008 or 2009, very likely most of the costs (i.e., traditionally 39-year property) can qualify for 15-year tax depreciation treatment. Even better, QLHI property is also eligible for 50% bonus depreciation during these years.

The tax provisions for bonus depreciation and QLHI treatment have not yet been extended for the 2010 calendar year. On June 24, 2010, the Senate denied yet again (by a vote of 57-41) Senator Baucus' Senate Bill, "Bonus Depreciation Extension to Create Jobs Act," which would have extended bonus depreciation through December 31, 2010. This was the third substitute amendment to H.R. 4213, or "American Jobs and Closing Tax Loopholes Act of 2010," which passed in the House (by a vote of 215-204) on May 28, 2010. Only days earlier, the Senate voted 56-40 against the second amendment. While the discussions continue to ensue in the Senate, many lawmakers see the extension of bonus depreciation as a much needed tax break to both small and large businesses alike, and it is continuing to be debated for extension.

Retroactive or "Look Back" Analysis for Assets Placed in Service in Prior Years

Conducting a thorough cost segregation study can also help to identify and properly classify short lived assets for prior year real property and leasehold construction projects, amounting to a substantial current year tax deduction. Understated depreciation from prior tax years can be taken in the current tax year by filing a Form 3115, Change in Accounting Method, which can be filed by the due date of a taxpayer's tax return, including extensions.

Conducting a Cost Segregation Study

WTAS cost segregation professionals recognize the time restraints that client personnel are under and our methodology is designed to minimize time and effort from clients. Significant tax benefits of a WTAS cost segregation study generally result from the following steps (as necessary):

• Review of capitalized costs and documentation
• Site inspection of the property
• Cost allocation and documentation analysis
• Asset-by-asset tax authority citation
• Computing understated depreciation and filing Form 3115 (for retroactive studies)
• Audit support

Even if an entity owns facilities purchased or constructed in prior years, a cost segregation study can be conducted retroactively. WTAS follows established and IRS-accepted engineering analyses that allows for the identification and estimation of personal property within older buildings without invoices or construction drawings.

Tax Planning

If a company is currently bidding out a construction project, or has recently engaged with a general contractor, WTAS will work with the contractors before and during construction to maximize personal property and site improvement asset classification. This offers even further opportunity to maximize short-lived property identification by analyzing the construction spending as it occurs and review of contemporaneous construction documents. WTAS can also provide electronic asset reports to allow for an upload of the study results into your fixed asset depreciation system.