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Cost Segregation

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Cost Segregation

1031 Exchanges and Cost Segregation

For certain property owners, cost segregation is similar to bonus depreciation for owners of equipment.

We know that Section 1031 Exchanges reduce the financial costs of owning business and investment assets by:

  1. Reducing income taxes in the year of sale.
  2. Reducing future debt and interest expense by reinvesting 100% of equity into new property.
  3. Allowing losses to be deducted while excluding gains.

Additionally, in the case of equipment, the following also apply:

  1. Exchanges reduce depreciation recapture.
  2. Exchanges reduce the cost of investing in new technology,
  3. May increase depreciation deductions overall.

Cost Segregation.

Property owners depreciate commercial property over 39 years and residential properties over 27.5 years. Cost Segregation accelerates these deductions over a shorter time period by separating (or segregating) the cost of the building into separate categories based on their useful life.

Based on established IRS rules, some assets might have a 5, 7 or 15 year useful life. Those assets can be deducted over their shorter tax life, allowing the owner to reduce its taxable income in the earlier years and allowing more cash to stay in their pocket.

A cost segregation study begins with an engineering based study to identify and separate various structural components of the building. This study is then used to file an automatic change of accounting method with the IRS and is the basis for the depreciation deductions on the tax return.

This can be used for both newly acquired or built structures as well as existing structures. A cost segregation study can go back as far as 1987 and can generate deductions in the current year based on accelerated deductions in those prior years. The success of this strategy is based on using a reputable Cost Segregation company with strong references and a solid track record.

Cost Segregation allows building owners to accelerate deductions for commercial and residential real estate. Faster tax write-offs result in cash savings to use elsewhere in the business. If the building has been owned for years, deductions attributable to prior years can be taken in the first year of the study.

Types of Properties that typically benefit from a cost segregation study:

  • Manufacturing Retail Stores Restaurants
  • Hotels Auto Dealer Golf courses
  • Medical Offices Apartments Grocery Stores
  • Leasehold Improvements Biotech Pharmaceutical

Examples of some typical structures in the retail business that can be Written-off more quickly:

  • Foundations for signs, poles, gas pumps and canopies;
  • Electrical connections for specific machinery and equipment;
  • Fire detection or suppression systems;
  • Floor coverings installed by means of strippable adhesives;
  • HVAC units to meet temperature and humidity requirements;
  • Plumbing connections for equipment and machinery;
  • Machinery, equipment, furniture and fixtures;
  • Land improvements, including sidewalks, parking, curbs, signs, site work;
  • Wall coverings, interior partitions and window treatments.

These guidelines are illustrative only and should not be relied upon as a substitute for a cost segregation study prepared by a construction engineer and cost accountants. Cost segregation benefits clients that continue to invest in the same type of business properties.

Summary of Benefits utilizing Cost Segregation

  1. Larger depreciation deductions may be taken over a shorter period of time. In the case of property that qualifies for Section 179 (or bonus depreciation), this can be taken immediately. Where the building has been owned for some time, all prior deductions can be taken in the year of change.
  2. Income tax savings improves cash flow. These funds can be used to either pay down debt to reduce debt and interest expense, or invest in other business investments and receive an additional rate of return on that cash flow.
  3. Building components and other assets that become outdated ordamaged can be written off quickly when such items need replacement.
  4. Lowering the portion attributable to real estate can lower local realty transfer taxes and reduce local property taxes.
  5. Cost segregation is not limited to new buildings, but can be applied to renovation, remodeling, restoration, or expansion and the acquisition of older buildings on or before Jan. 1, 1987.
  6. The taxpayer does not have to amend earlier tax returns Summary of Potential Detriments for Cost Segregation Studies Sale or Exchanges. When a building that has been subject to a cost segregation study is sold as part of an 1031 exchange, the property(ies) to be acquired should be of the same general type, so that the assets segregated into the 5, 7 and 15 year assets can be matched on the subsequent acquisition.

If the shorter life assets are not matched on the subsequent purchase, the taxes on the gain, if any, from the depreciation recapture must be paid at the time of the sale at higher ordinary income tax rates.

Cost segregation studies not utilizing competent engineers are likely to be rejected and penalties imposed for negligence and disregard of the rules and regulations.

Brief Overview.

Under pre-2014 law, the determination of whether an expenditure was a capital improvement focused on whether the expenditure:

  1. substantially prolonged the useful life of the property;
  2. materially increased the value of the property; or
  3. adapted the property to a new or different use.

These rules are replaced with “restoration” and “betterment” standards. The betterment standard focuses on the condition of the property, the costs of which should be capitalized as an improvement if the betterment is material regardless ofwhether the betterment increases the fair market value. The regulations require a taxpayer to capitalize all the indirect costs of an improvement, including otherwise deductible repair or component removal costs that directly benefit or are incurred by reason of an improvement.

The Treasury regulations provide the following example:

X Co. owns retail stores that it routinely remodels/refreshes to ensure a good customer experience. The stores are remodeled to make them more attractive and the merchandise more accessible to customers in order to increase customer traffic and sales volume. This includes decorative, cosmetic and layout changes to the store's interiors and general repairs and maintenance to the store building.

The Regulations provide that the amounts that X Co. pays for the remodeling of its stores result in betterments to the buildings' structures under Regs. §1.263(a)-3T(h). Specifically, amounts paid routinely to upgrade its stores materially increase the productivity, efficiency, and quality of X Co. stores. Generally, unless otherwise indicated, these amounts would be capitalized over the life of the building structure.

The Regulations also provide that amounts paid to improve real or personal property for resale must be capitalized under Section 263A. Furthermore, the Regulations provide incentive to building owners to utilize cost segregation services in order to carefully identify those assets which can be rapidly written off since the new tax regulations are likely to require the capitalization of expenditures spent on buildings that do not qualify under the new safe harbor for routine maintenance and repair expenses.

Contact us to determine if your building may qualify for cost segregation services.

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