Legalities and Benefits of Cost Segregation
|Copyright 2014 by Virgo Publishing.|
|By: Kathleen Humen|
|Posted on: 03/01/2004|
As we close the books on another fiscal year, self-storage owners should be looking for ways to keep more of their money. If you are depreciating your facility over 39 years, you may be sitting on a financial windfall through the use of cost segregation. While the window tends to close rather rapidly on most traditional methods of deferring taxes, cost segregation for 2003 can be completed until September 2004. With cost segregation, you may get back a large portion of those estimated payments.
Self-storage is perfect for cost-segregation techniques, since as much as 30 percent of the costs can be classified to accelerated recovery periods. For instance, instead of 39 years, site improvements can be recovered in 15 years. By accelerating the recovery period, the owner’s benefit is a function of deferment of taxes.
Relatively new and implemented only by some of the most sophisticated developers/owners, cost segregation is often looked at by ownership as a competitive advantage. Basically, it is an excellent method for the deferment of taxes. You can pay your taxes years later while using the saved money to increase your investment returns. For example, a costsegregation study on a typical 45,000-square-foot facility could double the after-tax cash flow in the year 2003, depending when the facility was placed in service.
The 1997 landmark case of The Hospital Corp. of America vs. the Commissioner opened the door to accelerated depreciation techniques. Later, in 2003, the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) was enacted to stimulate the economy. The act expanded the bonus depreciation from 30 percent to 50 percent for new assets acquired after May 5, 2003.
In short, this provision allows a one-time deduction of 50 percent of the cost of MACRS (Modified Accelerated Cost Recovery System) property with a class life of 20 years or less. For example, if you spend $100,000 on land improvements, you can deduct $50,000 of the cost immediately and depreciate the remaining balance over the normal recovery period. In addition to the bonus depreciation, the Section 179 expensing election increased from $25,000 to $100,000.
Regardless of Section 179 and bonus depreciation, self-storage owners should not overlook the benefits of segregating various building costs into separate categories as defined by the IRS. Instead of depreciating an entire self-storage complex over 39 years, the new blended rate of depreciation provides a reduced recovery period. But the court decision goes even further by allowing you to claim catch-up depreciation. This is the depreciation you could have claimed in prior years, had cost segregation been permitted, all the way back to 1987.
A successful cost-segregation study requires:
Why is self-storage such an ideal candidate for cost segregation? Because of the vast amount of site work required vs. the overall cost of building improvements when compared to other structures. Site work (asphalt paving, sidewalks, storm-water drainage, curbing, fencing, security lighting, underground utilities, etc.) was specifically identified by the IRS as a separate asset category with a reduced life compared to the actual building or buildings (15 years vs. 39 years). Furthermore, there are other systems that can be depreciated over five- to seven-year periods, such as CCTV security, controlled-access gates, computerized locking or alarm systems, etc.
Like most people, you are probably wondering, “Why hasn’t my accountant told me about this?” The answer is, the process was only permitted about three years ago, and it has taken time for firms to develop the skill sets necessary to conduct such studies. These resources include engineering expertise and cost estimating, two disciplines most accounting firms do not have internally.
Firms typically look to the engineering profession to complete the study with all the property reclassifications. The accountant takes the study and its detailed support, recalculates the depreciation, and prepares Form 3115, “Change in Accounting Method,” which is an automatic change-approval process. The engineering-based study does not replace the accountant’s role in determining or preparing your tax-return information. However, it does provide your accountant the correct depreciation figures so the IRS forms are completed in line with allowable practices. This whole process is akin to the accountant working with an appraiser in determining the land component on a nonresidential real estate transaction.
The tax savings for self-storage facilities are usually significant, since a much higher percentage of their construction costs are sitework related than in other types of buildings. Let’s look at a typical 50,000-square-foot, single-story facility. The depreciable basis includes the direct and indirect costs associated with the building, site work and personality. (The basis excludes land, as it is not depreciable.) For the purposes of this example, let’s say the direct and indirect costs are $28 per square foot for a depreciable basis of $1.4 million.
In my experience, 30 percent of the depreciable basis can be re-categorized to shorter recovery periods (15 years, seven years and five years) instead of all of it being depreciated over 39 years. This reclassification tax, affected at 45 percent and discounted at 6 percent, yields the taxpayer an NPV (net present value) tax benefit of $75,000 over 15 years. That is an extra $75,000 of real, bottom-line money in the owner’s pocket.
Once cost segregation is understood by owners and, most important, their accountants, the question is: How could you not do it? Whether you acquired a facility after 1986, are planning to buy a facility, or embarking on a building program, cost segregation and the bonus depreciation available under the JJGTRRA should be part of your self-storage strategy to increase cash flow and reduce ongoing expenses.
Kathleen Humen is the director of tax compliance for Construction Cost Recovery Inc., headquartered in White Plains, N.Y. The firm specializes in such services as cost segregation with a focus on self-storage. Ms. Humen can be reached at 914.694.3800. For more information, visit www.ccrtaxaudit.com.