Author: Luis A. Guerrero, CPA, MBT | Publication: CPA/Law Forum Newsletter
Another Cost Segregation article you ask? By now you have probably read a dozen articles on the benefits of a Cost Segregation study. You are wondering whether or not it is worth your time to be reminded of these benefits when you are really looking for some insight into the less obvious issues surrounding this great tax planning opportunity.
There has been a flood of activity in the area of Cost Segregation ever since the IRS issued its Action on Decision 1999-008, 9/8/1999 and its Chief Counsel Advice 199921045 in response to the Tax Court’s findings in Hospital Corporation of America (HCA), 109 TC 21 (1997).What was once limited to the large accounting or consulting firms and their Fortune 500 clients have rapidly become commonplace with the average taxpayer. Cost Segregation is an engineering based approach to classifying the costs of a building structure into their proper depreciable lives. In HCA, the Tax Court determined that the test (of what was tangible personal property) developed under Investment Tax Credits before 1981, continues to impact the answers to similar questions in cost recovery (depreciation) issues.
Prior to 1999 most tax professionals outside the major accounting firms would allocate the purchase price of real property into land and building and would then depreciate the building over 27.5 or 39 years (depending on whether it was residential or commercial property).
The hundreds of court cases culminating with the Tax Courts findings in HCA in 1997 and the IRS’s 1999 acquiescence (at least in part) has lead to a substantial acceleration of depreciation deductions for your average taxpayer. Now your typical residential or commercial property is broken down into 5, 7 and 15-year assets (in additional to the structural component), resulting in substantially larger deductions in the early years a property is held.
By now you have seen a chart that details the change in depreciation and the resulting present value benefit. What has not been discussed often is the variety of issues and opportunities created by implementing the results of a Cost Segregation study.
Issues & Opportunities
Change of Accounting Method; Depreciation on Assets Acquired in a Prior Year – Cost Segregation applies to more than just property acquired in the current year. In fact, any property qualifies (although as a practical matter there is no benefit to doing a study on a property acquired prior to 1987, given that depreciable lives were 19 years and shorter).
Until recently, there was some conflict as to whether this represented a change of accounting method or the correction of an error. This dilemma has since been resolved by Rev. Proc 2004-11, 12/30/04 which established that changes of depreciable lives or methods were in fact a change of accounting method.
Rev. Proc. 2002-9 (which replaced Rev. Proc. 99-49) provided guidance on implementing the results of a Cost Segregation study on assets acquired in a prior year. Rev. Proc. 2002-9 provides automatic approval for depreciation changes that meet certain requirements. Initially, the IRS mandated a 4 year section 481 adjustment which has since been modified to a one year 481 adjustment equal to the missed deprecation.
Change of Accounting Method; Audit Risk – While all applications for automatic changes in depreciation get reviewed by an IRS representative in the National Office, there is no evidence that a properly conducted study results in any additional audit risk. Informal conversations with IRS representatives have indicated that studies that meet certain minimum procedural requirements and whose allocation fall within certain unstated parameters, are not selected for any additional review (other than the review of Form 3115 and supporting documentation provided with the change of accounting application).
Change of Accounting Method; Multiple Change Restriction – Caution should be taken when addressing multiple properties held by the same entity. Rev. Proc. 2002-9, Section 4.02(6) states that the automatic change procedures do not apply if the taxpayer, within the last five years requested a change in the same accounting method. Therefore, a taxpayer with multiple properties within the same entity is required to make the change for all properties for the same year with one Form 3115 application unless they are willing to wait 5 years before applying again.
Estate Planning – Cost Segregation can enable a group of taxpayers to depreciate the same property three times. How is this possible? It is rather straight forward once you have thought it through. For example, a doctor and his/her spouse purchase a medical facility. They have a Cost Segregation study performed on the property and depreciate it for a period of time. One spouse passes away and a second study is performed on the property based on its fair market value on the date of death (ignoring the issue of community property vs. separate property states) and the depreciation starts over. Upon the death of the second spouse, the heirs inherit the property, conduct a study and start the depreciation over again (for a third time) with no taxable gain or depreciation recapture!
Bonus Depreciation & 179 Deductions – A Cost Segregation study provides a taxpayer with information needed to take bonus deprecation and the Section 179 deduction.
Property Tax – Addressing the proper allocation of the cost of an acquired property to real and personal property gives the taxpayer the opportunity to reduce long-term property tax cost. By identifying the fixtures and the equipment in a real property acquisition, the taxpayer is in the position to have a portion of the purchase price allocated to assets whose taxable base goes down with time (the equipment portion) and reduced the portion of the taxable base that goes up with time (the real property portion).
Like-Kind Exchanges; New Temporary Regulations and the Election Out – Property acquired in a 1031 Like Kind Exchange adds a wrinkle to the Cost Segregation question. Generally, property acquired in a 1031 is depreciated in part based on the carryover basis of the property given up in an exchange, and in part by any additional cost of the newly acquired property. Very extensive and detailed temporary regulations (1.168(i)-6T) were issued February 27, 2004 (T.D. 9115) regarding this issue. While the details are beyond the scope of this discussion, it is necessary to note that the outcry regarding the complexity of these new regulations was anticipated by the Treasury. As a result, Tres. Reg. 1.168(i)-6T(i) provides an election out of the new regulations. This election allows a taxpayer to treat a property acquired in a Like-Kind Exchange as if it was a newly acquired property. While often not preferable, this election can work to the taxpayer’s advantage in circumstances where no Cost Segregation study was performed on the relinquished property, and a sufficient step-up (to prevent any boot on the exchange) has occurred on the acquired property.
Like-Kind Exchanges; State Law Determination – At least to some degree state law is considered in determining if property is of a like kind. Many states define real property differently. Some states included fixtures in their definition of real property. This classification provides the best of both worlds for taxpayers, an increased five or seven year basis for depreciation and a reduced non real property bucket of assets that need to be addressed in a 1031 exchange (i.e. reducing the risk of boot when transferring real property).
Abandonment Studies – Assume that your client purchases an office building with multiple tenants. By conducting an abandonment study (similar to a Cost Segregation study) and identifying the assets by tenant, a taxpayer is able to write-off any un-depreciated basis at the termination of a lease, including 39-year tenant improvements!
Lease Negotiations – Landlord vs. Tenant – How a lease agreement is drafted dictates the type of depreciation deduction a landlord and a tenant are entitled to when allowances are made. If a lease agreement calls for the landlord and the tenant to split the cost of improvements, planning before the lease is signed will enable you to provide your client (whether it is the landlord or the tenant) with the most advantageous allocation. For example, assuming you are representing the landlord who has agreed to grant the tenant $50,000 in allowances toward the build-out of a particular space in a strip mall. Stipulating in the lease the assets to be acquired by your client will enable them to take depreciation on shorter-lived assets.
Depreciation Recapture – Some practioners argue that performing a Cost Segregation study increases the amount of ordinary income from depreciation recapture on 1245 property and (to a lesser extent for corporate taxpayers) on 1250 property. The problem with this view is that a Cost Segregation study does not create 1245 property; it just identifies it. As is the case with all tax positions taken, it is better for the taxpayer to make their own determination (and then defend it upon audit) than it is to let the IRS decide what the proper allocation should be (and then try to argue differently).
While it is clear that the IRS has not yet focused on this issue, odds are that as they increase their scrutiny of Cost Segregation, they will also look at other areas in which tax revenue could be enhanced. At some point they will realize that while there is an acceleration of depreciation deductions through a Cost Segregation study (resulting in reduced current revenue) there is also a rate deferential (on the sale of the property) to their benefit that needs to be address. As mentioned earlier, it is better for the taxpayer to drive this process than it is to let the IRS do so. Furthermore, the taxpayer has the opportunity to mitigate the ordinary income piece upon disposition of the 1245 property assets if they are aware and in control of the issue.
Passive Losses vs. Real Estate Professionals – No benefit is derived from a study that creates losses if your client is a passive investor in real property. However, taxpayers with multiple properties can often qualify as a real estate professional enabling them to offset other income with losses created by the added deprecation realized by a study. For example, you will often have a client who is a real estate broker that has invested in several properties throughout the years. By qualifying as a real estate professional, your client is entitled to offset the income from their broker activities with losses from their real estate holdings. Taking the concept one step further, should the added depreciation create net operating losses, the real estate professional can carryback the losses to offset income in prior years.
Construction Engineers and Tax Consultants – In December of 2004, the IRS issued its Audit Techniques Guide (ATG) with respect to Cost Segregation Studies. In Chapter One of the ATG, the IRS advises its agents that the “Detailed Engineering Approach” whether from actual records or from construction estimates usually results in the most reliable allocations.
In Chapter Four, they go on to list their 13 “Principal Items of a Quality Cost Segregation Study”. The first of these 13 items is the qualifications of the person preparing the study. Here the IRS indicates that the person conducting the study should possess knowledge of the “construction process and tax law involving property classification for depreciation purposes”.
Based on the specific guidance provided by the IRS, it is important that studies be performed by a firm using the Engineering Approach and employs both construction engineers and tax professionals.
While the above is not a comprehensive list nor does it provide a detail analysis of the various subjects discussed, it does provide a sampling of the various issues and opportunities not often addressed in many cost segregation discussions. Each one of these topics requires a much more detailed analysis but should give you a foundation for addressing these matters with your clients. Watch for a more detailed analysis of selected items in upcoming issues.
Luis A. Guerrero, CPA, MBT 626-449-4225, Extension 131; [email protected]